How to Calculate the Predetermined Overhead Application Rate for Absorption Costing Purposes

When calculating the full cost of a product or service, a company first allocates all direct material and labor costs and direct expenses on a per-unit basis. Overhead costs are those that the business cannot directly attribute to production units, but must still include in overall costs to accurately compute a profitable selling price. As cost accountants cannot know the full cost of overheads until after they're incurred, they predetermine an absorption rate to apply to overhead costs during the accounting period. At the end of the period, they compare actual costs to absorbed costs and make an adjustment for the difference.

  1. 1.

    Examine the historic activity levels of each type of direct cost to determine which one will be the basis of the overhead application rate. Choose an activity that is used in the production of all types of output and which has a significant effect on total direct costs. For example, if the product or service is labor intensive, you could use direct labor costs or direct labor hours. Alternatively, if the factory is highly automated, machine hours would be a more appropriate basis. Companies that offer only one kind of service or produce a single type of product could use production volume as the basis of the calculation.

  2. 2.

    Divide the total budgeted overhead costs for the period by the expected value of the direct activity chosen over the same period. For example, if you're using direct labor hours as the cost basis, divide total budgeted overheads by total expected direct labor hours and multiply the result by 100 to calculate the rate. If total budgeted overheads for the year are $50,000, and total projected direct labor hours for the year are 25,000, divide $50,000 by 25,000, which equals 2. Multiply 2 by 100 to obtain an absorption rate of 200 percent. This means that $2 of overheads will be absorbed for every direct labor hour worked.

  3. 3.

    Multiply the actual direct cost by the overhead application rate to calculate the overhead absorbed during the year and compare it with actual overheads incurred. In the example used, if actual direct labor hours totaled 22,000, the overhead absorbed would be 22,000 multiplied by 200 percent, or $44,000. If the actual cost of overheads incurred was $50,000, overheads would be under-absorbed by $6,000 for the year. An adjustment would be made in the cost ledgers to reflect this and ensure that the profit-and-loss statement showed the actual costs incurred.