Overhead absorption is the amount of indirect costs assigned to cost objects. Indirect costs are costs that are not directly traceable to an activity or product. Cost objects are items for which costs are compiled, such as products, product lines, customers, retail stores, and distribution channels.
Overhead absorption is a necessary part of the requirement by both the GAAP and IFRS accounting frameworks to include overhead costs in the recorded amount of inventory that is shown in a company's financial statements. Overhead absorption is not needed for internal management reporting, only for external financial reporting.
Examples of indirect costs are:
- Selling and marketing costs
- Administrative costs
- Production costs
Selling, marketing, and administrative costs are usually charged to expense in the period incurred. However, indirect production costs are classified as overhead and then charged to products through overhead absorption.
Overhead absorption involves the following steps:
- Classify indirect costs. Depending on the type of allocation desired, some costs may be included in overhead and others may not. For example, overhead absorption for a product would not include marketing costs, but marketing costs might be included in an internal cost report for a distribution channel.
- Aggregate costs. Shift the identified costs into cost pools. Each cost pool should have a different allocation base. Thus, the indirect costs related to a facility might be aggregated into a cost pool that is allocated based on square footage used.
- Determine allocation base. This is the basis upon which overhead is assigned to a cost object. For example, facility costs may be assigned based on square footage used, while labor-related indirect costs may be assigned based on direct labor used.
- Assign overhead. Divide the allocation base into the total amount of overhead included in a cost pool to arrive at the overhead rate.
Overhead absorption is based on a combination of the overhead rate and the usage of the allocation base by the cost object. Thus, the allocation of overhead to a product may be based on an overhead rate of $5.00 per direct labor hour used, which can be altered by changing the number of hours used or the amount of overhead cost in the cost pool.
Overhead absorption does not necessarily reflect the exact amount of overhead cost actually incurred during an accounting period, since the overhead rate may be a long-term one that was based on information derived at some point in the past. If so, the amount of overhead absorbed may differ from the amount of overhead actually incurred.