The process of charging or apportioning the overheads of the cost centers to cost units is known as “absorption”. After ascertaining the total costs of overheads by means of allocation, apportionment, and re-apportionment, they should be charged to cost units. It is important to distribute the overheads for computation of cost of production.
The total overhead costs of a production cost center consist of:
- Its own direct cost e.g. indirect material, indirect wages, depreciation of machinery etc. (allocation)
- Share in expenses common to various departments e.g. factory rent, power, lighting, building insurance etc. (apportionment).
- A share in the total cost of service departments (re-apportionment).
There are two steps in the absorption of overhead cost to cost units/products.
- Computation of overhead absorption rate.
- Application of overhead absorption rate to various cost units/products.
The rate at which overheads, are charged to different cost units/products is known as Absorption rate. It can be in the form of percentage, a rate per unit of product per machine hour, per labor hour etc. After this the overhead cost can be calculated by multiplying overhead unit’s rate with units of base in cost units.
For example: if the overhead cost of production department is Rs. 50,000 and total direct wages for different jobs completed in that department are. Rs. 2,00,000 the overhead absorption rate will be 25% on wages now, if wages are incurred on a particular job are Rs: 2,000 the overhead cost will be Rs. 500 (25% of Rs. 2000 ) similarly if hours were to be taken as the basis of charging overheads, number of hours worked in that department is 1,000 hours, the overhead absorption rate will be Rs. 50 per hour (50,000/1,000) now if the job is taken for complete. 12 hours, the overhead cost of that job will be Rs. 600 (50 x 12).