Absorption of Overheads is defined as the under absorption and over absorption of overheads.
Overhead absorption is the amount of indirect costs.Indirect costs aren't directly related to an activity or product.Cost objects include products, product lines, customers, retail stores, and distribution channels.The GAAP and IFRS accounting frameworks require that overhead costs be included in the recorded amount of inventory that is shown in a company's financial statements.External financial reporting does not need overhead absorption.There are indirect costs.
Administrative costs are usually charged to expense.Indirect production costs are charged to products through overhead.
Classify indirect costs.Overhead may or may not include some costs depending on the type of allocation desired.Overhead absorption for a product wouldn't include marketing costs, but they might be included in an internal cost report for the distribution channel.
Aggregate costs.The identified costs should be shifted into cost pools.There should be a different allocation base for each cost pool.The indirect costs might be aggregated into a cost pool based on the square footage used.
Determine the allocation base.Overhead is assigned to a cost object on this basis.It is possible to assign facility costs based on square footage used, while labor-related indirect costs may be assigned on direct labor used.
Overhead should be assigned.To arrive at the overhead rate, divide the allocation base into the total overhead included in the cost pool.
The overhead rate and allocation base are used to calculate overhead absorption.Changing the number of hours used or the amount of overhead cost in the cost pool can change the overhead allocation to a product.
Overhead absorption doesn't reflect the exact amount of overhead cost actually incurred during a reporting period, since the overhead rate may be a long-term one that was based on information derived at some point in the past.The overhead absorbed may be different from the overhead actually incurred.