Overhead absorption is a financial term used to describe a business's operating expenses. Specifically, it expresses a relationship between the business's indirect operating costs and its rate of production. Knowing how to calculate overhead absorption is useful because it allows you to determine the efficiency with which products are made. It also helps you make more informed decisions regarding potential investments.
Step 1
Determine the total amount of overhead for a given period. A business's overhead is another name for all of its indirect operating costs such as rent, utilities, and taxes. These expenses are necessary for the operation of a business but they do not contribute directly to production. Overhead does not include direct expenses such as the cost of wages and wholesale goods.
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Step 2
Determine the overhead absorption base. This is the total number of labor hours dedicated to operations during the overhead period. For example, if you were trying to determine the overhead base for a one-month period, you would add together all the labor hours for that month.
Step 3
Divide the overhead by the overhead absorption base. The result is the overhead absorption rate. For example, if you had an overhead cost of $10,000 and an overhead base of 1,000 labor hours, you would divide 10,000 by 1,000 to get an overhead absorption rate of $10 per hour.
Tip
If you prefer, you can substitute labor cost for labor hours when determining the overhead absorption base.
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