The rate of absorption

Overview of the Rate of Absorption

The rate of absorption is the predetermined rate at which overhead costs are charged to cost objects (such as products, services, or customers). The rate of absorption drives the amount of overhead costs that are capitalized into the balance sheet of a business.

This rate is based on the historical relationship between the amount of cost usually accumulated in a typical overhead cost pool and the basis of allocation. The resulting rate of absorption is then used to allocate overhead to cost objects in the current period.

The rate of absorption may be changed in each successive accounting period to reflect changes in the overhead cost pool and the basis of allocation.

Example of the Rate of Absorption

The controller of ABC International concludes that it is reasonable to charge factory overhead to products based on their use of machine time in the production facility. He calculates this rate of absorption based on the information in the preceding period. During that time, ABC incurred $240,000 of factory overhead costs, and operated its machinery for a total of 6,000 hours. Based on this information, the rate of absorption is determined to be $40 per machine hour (calculated as $240,000 overhead costs divided by 6,000 machines hours).

At the end of the current period, the cost accountant applies overhead costs to products using the $40/machine hour rate of absorption. The amount of overhead cost actually incurred matched the amount in the preceding month. However, since machinery was only used for 5,500 hours during the month, this resulted in the underallocation of overhead costs of $20,000 (calculated as $40/machine hour rate of absorption x 5,500 machine hours used, subtracted from the $240,000 overhead cost pool). The residual $20,000 of overhead that was not allocated is charged to expense in the current period.