Overhead Absorption

Definition

Overhead absorption is the process of allocating and distributing overhead costs to products or services in order to determine the full cost of production. It is a critical component of managerial accounting, as it allows businesses to accurately price their offerings and make informed decisions.

5 Must Know Facts For Your Next Test

1. Overhead absorption is necessary to determine the full cost of a product or service, which includes both direct costs and indirect overhead costs.
2. The choice of cost allocation method, such as direct labor hours or machine hours, can significantly impact the overhead absorption rate and the resulting product costs.
3. Underapplied overhead occurs when the actual overhead costs are higher than the predetermined overhead costs that were applied to production, while overapplied overhead occurs when the actual overhead costs are lower than the predetermined overhead costs.
4. Proper overhead absorption is crucial for accurate pricing decisions, inventory valuation, and performance evaluation of production departments.
5. Analyzing and addressing underapplied or overapplied overhead can help businesses improve their cost management and decision-making processes.

Review Questions

• Explain the purpose of overhead absorption in the context of managerial accounting.
  • The purpose of overhead absorption is to allocate and distribute indirect overhead costs to individual products or services in order to determine their full cost of production. This information is crucial for accurate pricing decisions, inventory valuation, and performance evaluation of production departments. By understanding the true cost of their offerings, businesses can make more informed decisions about pricing, production, and resource allocation.
• Describe the process of determining and disposing of underapplied or overapplied overhead.
  • Underapplied overhead occurs when the actual overhead costs are higher than the predetermined overhead costs that were applied to production, while overapplied overhead occurs when the actual overhead costs are lower than the predetermined overhead costs. To address this, businesses must first calculate the difference between the actual and applied overhead costs. This difference can then be disposed of by closing it out to the cost of goods sold account (for underapplied overhead) or to a separate overhead variance account (for overapplied overhead). Analyzing and addressing underapplied or overapplied overhead can help businesses improve their cost management and decision-making processes.
• Evaluate the importance of choosing an appropriate cost allocation method for overhead absorption and its impact on product costing.
  • The choice of cost allocation method, such as direct labor hours or machine hours, can significantly impact the overhead absorption rate and the resulting product costs. A well-chosen cost driver that accurately reflects the relationship between overhead costs and production activities is crucial for accurate product costing. If the cost allocation method is not aligned with the underlying cost drivers, it can lead to distorted product costs, which can result in suboptimal pricing decisions, inefficient resource allocation, and poor performance evaluation. Carefully evaluating and selecting the appropriate cost allocation method is essential for ensuring the accuracy and reliability of overhead absorption and the resulting product costs.

Related terms

Overhead: Overhead refers to the indirect costs of operating a business that cannot be directly attributed to the production of a specific product or service, such as rent, utilities, and administrative salaries.

Cost Allocation: Cost allocation is the process of assigning overhead costs to cost objects, such as products, services, or departments, based on a chosen cost driver or allocation base.

Predetermined Overhead Rate: A predetermined overhead rate is an estimated overhead rate that is calculated and used to apply overhead costs to production during an accounting period, before the actual overhead costs are known.