# Overhead Absorption (Applied Overhead)

> Source: https://netray.co/glossary/overhead-absorption
> Publisher: Netray (netray.co), AI and integration engineering for ERP and manufacturing systems.
> Section: Glossary

## Short answer

Overhead absorption is the process of charging indirect manufacturing costs, such as factory rent, utilities and supervision, to products or jobs using a predetermined rate based on labor hours, machine hours or another base.

## Aliases

- overhead absorption rate
- applied overhead
- manufacturing overhead absorption
- overhead rate

## Category

manufacturing

## Full Definition

Indirect manufacturing costs cannot be traced to a single unit, so they are absorbed through a rate. The predetermined overhead rate equals budgeted overhead for the period divided by the budgeted activity base, for example 600,000 of overhead over 20,000 machine hours gives 30 per machine hour. Each job or operation then absorbs overhead as it consumes the base.

Because the rate is set in advance and real costs differ, absorbed overhead rarely equals actual overhead. The difference is under-absorbed overhead (actual higher than applied) or over-absorbed overhead (applied higher than actual). It is usually posted to a variance account or to cost of goods sold at period end, and large balances call for revising the rate.

In ERPs the rate normally lives on the work center or routing operation. SyteLine work centers carry labor and machine overhead rates that are applied as operations are reported. NetSuite uses labor and overhead rates on manufacturing cost templates and work centers. SAP uses costing sheets and activity types with planned prices on work centers. Infor LN breaks overhead out as cost components on the cost price.

Absorption costing, which includes fixed manufacturing overhead in inventory cost, is required for external reporting under both US GAAP and IFRS, while variable costing is used only for internal analysis.

## Why It Matters

- Inventory and cost of goods sold include overhead only if it is absorbed, so the rate directly affects reported profit.
- A stale rate can leave large under- or over-absorption balances that distort monthly margins.
- Selling prices based on direct cost alone can miss overhead and lose money on every order.
- Rate maintenance is a control point auditors review when testing inventory valuation.

## In Practice

Budgeted overhead is 600,000 over 20,000 machine hours, so the rate is 30 per hour. The plant runs 18,000 hours and absorbs 540,000, while actual overhead is 580,000. Overhead is under-absorbed by 40,000, which goes to a variance account at close and prompts a review of the 30 per hour rate.

## Faq

### What is under-absorbed overhead?

**Answer:** It occurs when actual overhead exceeds the overhead applied to production through the rate. The shortfall is expensed through a variance account or cost of goods sold.

### What base should I use for the overhead rate?

**Answer:** Use the driver most related to overhead consumption: machine hours for automated shops, labor hours for manual work, or material cost where handling dominates.

### How often should the overhead rate be revised?

**Answer:** At least annually with the budget, and sooner if volume, headcount or facility costs change materially or variances grow large.

## Search terms

overhead absorption, applied overhead, overhead absorption rate, under absorbed overhead, over absorbed overhead, predetermined overhead rate, manufacturing overhead ERP, absorption costing

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