Absorption of overheads refers to charging of overheads to individual products or jobs. The overhead expenses pertaining to a cost centre are ultimately to be charged to the products, jobs etc. which pass through that cost centre. For the purpose of absorption of overhead to individual jobs, processes or products, overheads absorption rates are applied. The overhead rate of expenses for absorbing them to production may be estimated on the following three basis.
- The figure of the previous year or period may be adopted as the overhead rate to be charged on production in the current year.
- The overhead rate for the year may be determined on the basis of the estimated expenses and anticipated volume of production or activity.
- The overhead rate for the year may be determined on the basis of normal volume of output or capacity of the business.
Actual and pre-determined overhead rate: The overhead absorption rate may be computed either based on actual cost or on the basis of estimated cost:
Actual Overhead Rate
This is also known as historical overhead rate. This rate is obtained by dividing the overhead expenses incurred during the accounting period by the actual quantum (quantity/value) of the base selected. This rate is determined as follows:
Actual overhead rate = Actual overhead for the period Actual quantity or value of the base for the period
This method suffers from the following limitations:
- Actual overhead rate cannot be determined until the end of the period.
- Seasonal or cyclical influences cause wide fluctuations in the actual overhead cost and actual volume of activity.
- Actual cost is generally used for comparison with the predetermined figures for the purpose of control. Thus, it is useful only when compared with the established norms or standards.
Pre-determined Overhead Rate
Pre-determined overhead rate is determined in advance of the actual production and is computed by dividing the budgeted overhead expenses for the accounting period by the budgeted base for the period i.e.
Pre-determined overhead rate = Budgeted overhead for the period
Budgeted base for the period
This computation of a pre-determined overhead rate is more practical and has the following advantages:
- Pre-determined overhead rate facilitates product cost determination immediately after production is completed.
- In those concerns where the budgetary control system is in operation, all the data for the purpose of calculation of pre-determined overhead rate is available without any extra clerical cost.
- It is useful when cost plus contracts are undertaken.
- Cost estimating and competitive pricing offer ideal situations for use of pre-determined overhead rates.