Absorbed overhead, also known as applied overhead or recovered overhead, represents the proportion of an organization’s overhead expenses that are allocated to its production for a specified accounting period using the technique of absorption costing. This concept plays a crucial role in managerial and financial accounting, ensuring that all production costs are considered when determining product costs and pricing.
Historical Context
The concept of absorbed overhead has evolved alongside the development of cost accounting techniques. Absorption costing, introduced in the early 20th century, helped businesses more accurately capture the total cost of production, beyond direct materials and labor.
Types/Categories
- Fixed Overhead: Expenses that do not vary with production levels (e.g., rent, salaries).
- Variable Overhead: Costs that vary directly with production volume (e.g., utilities, indirect materials).
Key Events
- 1920s-1930s: Formalization of absorption costing principles.
- 1950s: Adoption of absorption costing in GAAP (Generally Accepted Accounting Principles).
- Modern Day: Widespread application in various industries for cost allocation and pricing strategies.
Detailed Explanations
Calculation of Absorbed Overhead
Absorbed overhead is calculated by multiplying the actual production for the period by the predetermined absorption rate. The absorption rate is typically established based on budgeted overhead costs and estimated production levels.
Importance
Absorbed overhead is crucial for:
- Accurate Product Costing: Ensures that all costs associated with production are reflected in product pricing.
- Financial Reporting: Essential for accurate financial statements.
- Decision-Making: Aids management in pricing, budgeting, and cost control.
Applicability
Absorbed overhead is applicable in:
- Manufacturing: To assign overhead costs to products.
- Service Industries: For allocating overhead to different service lines.
- Project-Based Environments: Ensuring project costs reflect overhead contributions.
Examples
- A factory producing 1,000 units with an absorption rate of $5 per unit will have absorbed overhead of $5,000.
- A consultancy firm allocates $20,000 of overhead to its projects based on direct labor hours.
Considerations
- Accuracy of Absorption Rate: Incorrect rates can lead to under or over-absorption of overhead.
- Production Variance: Significant deviations from estimated production can distort cost allocations.
Related Terms
- Overhead Costs: Indirect expenses related to the running of the business.
- Variable Costing: Only variable manufacturing costs are included in product costs.
- Standard Costing: Use of standard rates and amounts to manage costs.
Comparisons
- Absorption Costing vs. Variable Costing: Absorption costing includes fixed overhead in product costs, while variable costing does not.
- Overhead Absorption vs. Overhead Allocation: Absorption assigns overhead based on production levels; allocation can use various bases like direct labor hours or machine hours.
Interesting Facts
- The term “overhead” originates from construction where costs were literally above head level.
- Absorption costing is required by GAAP and IFRS for external financial reporting.
Inspirational Stories
Companies like General Motors and Ford in the early 20th century adopted absorption costing, enabling them to more accurately price their automobiles, leading to their market dominance.
Famous Quotes
“Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings.” – Diane Garnick
Proverbs and Clichés
- “You get what you measure” – reflecting the importance of accurate cost measurement.
- “Penny-wise, pound-foolish” – stressing the need to account for all costs, including overhead.
Expressions, Jargon, and Slang
- Overhead: General business expenses.
- Absorption Rate: The rate used to apply overhead costs to production.
- Under/Over-Absorption: Scenarios where actual overhead is less or more than absorbed overhead.
FAQs
What is absorbed overhead?
Why is absorbed overhead important?
How is the absorption rate determined?
References
- Horngren, Charles T., “Cost Accounting: A Managerial Emphasis”.
- Kaplan, Robert S., “Advanced Management Accounting”.
- Drury, Colin, “Management and Cost Accounting”.
Summary
Absorbed overhead is integral to the accurate allocation of costs within an organization using absorption costing. It encompasses both fixed and variable overhead costs, ensuring all production expenses are captured, thereby facilitating accurate product pricing, financial reporting, and effective managerial decision-making. Understanding absorbed overhead helps in maintaining financial accuracy and operational efficiency across various industries.
