Absorption of overheads is the process by which the total cost of a production centre is charged to the cost units within that centre. Absorption of overheads is charged to cost units based on an absorption rate and this is calculated at the beginning of the period based on budgeted activity and budgeted overheads. There are 3 methods of calculating the overhead absorption rate and the business can select the method they wish to use, depending on their production process.

1. Units of production

It may be possible to calculate how much overhead should be absorbed by each unit of product produced within the centre, having derived all allocated or apportioned overhead costs. The formula below would be applied:

Total budgeted overheads cost / Total budgeted units of production

Application:
Having derived the overhead absorption rate which is how much overhead that needs to be charged on each unit of product, the full production cost per unit can then be calculated.

Total overheads chargeable to a piece of work = overhead absorption rate x number of the units of products produced.

2. Direct labour hours 

Overheads can be absorbed based on the total number of direct labour hours to be worked in the production centre and then applied to specific jobs. This is normally used where the production involves heavy use of labour hours. In such case, the formula below would be applied:

Total budgeted overheads cost / Total budgeted direct labour hours

Application:
Total overheads chargeable to a piece of work = overhead absorption rate x number of direct labour hours consumed on the task.

3. Machine hours

Overheads can be absorbed based on the total number of machine hours to be worked in the production centre and then applied to specific jobs. This is normally used where the production involves heavy use of machine time. In such case, the formula below would be applied:

Total budgeted overheads cost / Total budgeted machine hours

Application:
Total overheads chargeable to a piece of work = overhead absorption rate x number of direct machine hours consumed on the task.