Absorption costing / overhead allocation process (detailed explanation)

In a production facility with multiple products, it’s challenging to determine production overheads for each product. So, we use the concept of overhead allocation using a predetermined overhead rate.

Overhead allocation enables us to trace the cost of each product. So we can analyze product profitability and make informed decisions using absorption costing.

Let’s understand how the process of overhead allocation works.

Step-1 (Select the object base)

Object base means selecting the basis for overhead allocation. For instance, in the machine-oriented environment – machine hours are selected as the object base; in a labour-intensive environment – labour hours are selected as the object base. The object-based approach can be different for different businesses depending on their nature and operations.

Step 2 (estimate the production overheads and level of activity for the object base)

Estimate the production overheads and object base. The estimate should be in line with the object base selected in the first step. For instance, if you have selected machine hours as the basis of allocation, estimate total machine hours and total production overheads. Similarly, if you had selected labour hours as the object base in the first step, the second step is to estimate total labour hours and total production overheads.

Step 3 (calculate the pre-determined overhead rate)

Divide estimated total production overheads with the level of activity for the object base. For instance, for machine hours, divide total production overheads by the total estimated machine hours. It gives us a pre-determined overhead rate, which will be used to absorb overheads in the next steps.

Step-4 (Absorb overheads based on actual activity level)

In this step, we need to note actual machine hours consumed in the production of a specific product and multiply them with the overhead absorption rate. In this way, the total overhead for each product is absorbed.

Let’s apply the given steps with an example.

Consider that the business produces three products: A, B, and C. The business operates in a machine-incentive environment. The following are the details.

Description	Product-A	Product-B	Product-C
Machine hours required	2	3	1
Prime cost	$10	$12	$8

Estimated production cost = $10,000

Estimated machine hour = 500

Step-1 (Select the object base)

In the first step, we have identified machine hour as the object base.

Step 2 (estimate the production overheads and level of activity for the object base)

We can copy from given data that Estimated production cost = $10,000 & Estimated machine hour = 500

Step 3 (calculate the pre-determined overhead rate)

We need to calculate the predetermined overhead rate as given below.

Overhead absorption rate = estimated production cost / estimated machine hours

Overhead absorption rate = $10,000/500

OAR = Overhead absorption rate =$20/machine hour

Step-4 (Absorb overheads based on actual activity level)

Description	Product-A	Product-B	Product-C
Prime cost	$10	$12	$8
(Machine hours required x OAR)	2 X 20=40	3 x 20= 60	1 x 20 =20
Total cost	$50	$72	$28

Based on the given details, we have calculated the total cost for each product.

Conclusion

Absorption costing is the method of absorbing production overheads in the product cost. This method involves identifying the absorption base in the first step. For instance, the absorption basis can be machine hours or labour hours, depending on the industry.

In the subsequent steps, total production overheads and level of activity are estimated, and an overhead rate is calculated.

A predetermined overhead rate is used to allocate manufacturing overheads in the product cost. It’s an estimated rate calculated via estimated cost for the estimated activity level.

After this stage, overhead absorption is absorbed in the product cost to arrive at the total cost.

It’s important to note that in absorption costing, the overhead absorption rate is a budgeted figure, and under/over absorption is calculated & adjusted accordingly.