What is overhead absorption?
Overhead absorption refers to the allocation of indirect expenses to cost objects. In this definition:
- Indirect expenses are expenses that cannot be directly attributed to a specific activity or product,
- Cost objects include all the sources of income in a given company, such as products, projects, customer groups, retail outlets, and product lines, for which expenses are aggregated.
In other words, overhead absorption helps you determine your project's operating expenses.
Are the costs of direct labor included in the overhead rate?
No - absorbed overhead is only calculated for additional, indirect costs affecting the project budget. Direct costs, such as direct labor hour, production costs, machine hours (in production industries) or manufacturing costs are not included in the equation.
What costs are included in overheads?
Overhead costs generally include:
- indirect costs, such as project's share of company's costs,
- raw materials and resources, such as software, subscriptions or devices,
- any additional production process that supports the projects, i.e. consultations or external support,
- recurring or fixed overheads, such as bills or taxes.
Overhead absorption formula
The formula for overhead absorption is:
The allocation base is a measure of the activity that drives the indirect costs. These might differ depending on the type of your company. Let’s see how it works in a real life example.
Overhead absorption step by step
The simplest calculation for overhead absorption rate includes the following steps:
Step 1: Identify your total overhead expenses
The first step in calculating overhead absorption rate is to identify all the indirect costs or overhead costs incurred by your business, or so-called company overheads. These costs may include rent, utilities, salaries and wages of support staff, depreciation, insurance, and other expenses that are not directly related to the production of goods or services.
Then, use the cost allocation formula to determine what costs should a given project cover.
Step 2: Determine your allocation base
The next step is to determine the allocation base or the factor that will be used to allocate overhead costs to the products or services produced by your business. The allocation base should be a measure of the activity that drives the overhead costs. For example, if your business incurs overhead costs based on the number of direct labor hours worked, then the allocation base could be the total number of labor hours worked by all employees.
However, there is more than one method of calculating overhead absorption rates - we described them all further in the article.
Step 3: Calculate your overhead absorption rate
To calculate the overhead absorption rate, divide the total overhead costs per unit by the allocation base. The general formula for overhead absorption rate is:
Step 4: Apply the overhead absorption rate
Once you have calculated the overhead absorption rate, you can apply it to the total cost of goods or services produced by your business to see how they affect the costs and, as a result, the profitability of your project.
Methods of calculating overhead absorption rate
In some product-based IT companies, it is common to calculate the overhead absorption rate based on the number of implementations of the product the company expects to complete in a given period. In that case, the overhead absorption formula is:
This formula can also be used in other industries - the only thing needed to adjust is to replace the number of implementations with the number of other produced units.
However, in a service-dominated IT industry, produced units are rarely used for calculating overhead absorption, as they do not reflect the amount of work in the project. Percentage and hourly rate methods are much better at it!
Fortunately for IT services companies, percentage methods for calculating overhead absorption offer much more accurate insights into the costs of operating expenses and their influence on project costs.
There are three ways to calculate overhead absorption in the IT industry using these techniques:
- Percentage of direct labor - or fixed costs in general,
- Percentage of prime cost.
Percentage of direct wages
In this method, overhead absorption rate is expressed as a ratio of actual or expected overhead costs to the actual or expected costs of wages needed to complete the project, multiplied by 100%.
Importantly, using the direct wages as a base for calculations ensures that the costs are allocated proportionally, as larger projects need to cover a larger fraction of overheads.
Percentage of prime costs - Prime cost method
Prime cost method is very similar to the one using only direct wages to allocate costs. However, in this case, costs of work are not the only ones that are included in the calculation; instead, the base for the calculations is direct labour cost with costs of direct materials and additional resources, such as equipment, subscriptions or additional programs, also known as prime costs.
Therefore, the formula for calculating overhead absorption rate is as follows:
Hourly rate methods
Another popular method of calculating overhead absorption rate in the IT industry is using rates or costs of the hours to establish project’s share of the operational costs. Here are two methods you can use to do this.
Direct labour hours
Calculating overhead absorption rate per labour hour is the simplest way to establish overhead costs. This method is also essential for calculating employee profitability.
In this method, however, the overhead absorption rate is calculated per one worked hour in the project using the formula:
For example, if a project is expected to take 500 hours in a given month and is supposed to cover $1000 of overheads, its overhead absorption rate is $2 per hour.
Costs per work expenses
Naturally, the previous formula can also be adapted to show the overhead absorption rate as a percentage. In this case, the formula is:
How can I manage my overheads better?
You can automate the process using Primetric!
Primetric contains several features for overhead management and allocations. In the system, you can add one-time and recurring overheads to the project to better control its profitability - just like in the picture shown below. Naturally, company overheads can be assigned to operations automatically!
You can also analyze overheads in the company as a whole. The information on additional costs are included in several advanced reports in the system, including the financial report. As a result, the system can provide you with a bigger picture of company’s additional spendings without creating extensive tables in Excel spreadsheets!
Of course, you do not have to believe us right away - start a trial with Primetric to see for yourself, or let our advisors help you and book a demo with them!
Where can I learn more about overheads?
If you want to read more about overheads or finance management in general, head to our blog and read about:
- revenue projection,
- selling fixed-price projects without losses,
- budgeting mistakes ruining profit margins in your company,
- project financial analysis,
- cost overrun - and how to prevent it.