Three examples of fixed manufacturing overhead costs include 1) depreciation of the manufacturing equipment, 2) the property tax on the factory building, and 3) the salaries of the factory supervisors. Each of these costs comes in large dollar amounts (they do not occur at a rate of say $1.00 per unit) and none is directly traceable to the products manufactured. The dollar amount of each of these costs will probably not change if the company produces 10% more units or 10% fewer units.
Because the fixed manufacturing overhead costs are indirect product costs (not directly traceable to the products) the accountant allocates (or assigns or applies) these costs to the products on some basis—perhaps on the basis of machine hours or through activity-based costing. While the accountant assigns or allocates these costs, the products are said to be absorbing these fixed manufacturing costs. (Absorption costing, which is required for external financial statements, means that each product's cost includes direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead.)
Fixed manufacturing overhead cost is usually applied to the products (and is absorbed by the products) through the use of a predetermined annual overhead rate that is based on some planned volume of production. If the actual product volume is less than the planned volume (and the costs are as planned) the fixed manufacturing overhead will be underabsorbed. When the actual volume exceeds the planned volume and the costs are as planned, the fixed manufacturing overhead will be overabsorbed.
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