Overhead absorption and absorption rates (OAR)

• As already pointed out elsewhere production overheads are usually calculated at the beginning of the accounting period
• This would allow, for example, the business to determine how much cost to assign to a unit before calculating the selling price
• The cost to be assigned to each cost object ( e.g.product unit) is calculated using  Overhead Absorption Rates (OAR)
• Overhead Absorption Rate (OAR) –is the rate to be used when assigning costs to products units or other cost objects
• In a case where there is a single department the following formula can be used
• \text{OAR=}\dfrac{\text{Budgeted Production Overhead}}{\text{Budgeted Total Of Absorption Basis}}
• The absorption basis is usually in the form of units of a product, labour or machine hours
• For example let us say Z Ltd expects their total indirect labour costs to be $5 000 and they expect to make two products A and B with 1 000 units of each to be made respectively.
• The Absorption rate could be $2.50 per unit for example i.e.
• \dfrac{\text{5 000}}{\text{1 000+1 000}}
• So each unit of production has to absorb $2.50 of overheads
• Things would be much more complicated if more than one product is being made which say take different labour hours to make
• As pointed out during the discussion of allocation and appointment
• It is not uncommon for a product to pass through more than one manufacturing department
• In a furniture factory for example a fabricated chair might move from the fabrication department to the finishing department
• In the finishing department a chair might be painted and decorated
• In such cases an overhead analysis sheet is used
• The format of the sheet is shown below

• In this case where there is more than one department and/or product
• First the overheads are allocated and apportioned to their various departments as shown in the sheet above and discussed here
• Then the total overheads for each department are calculated
• Each department will normally have its own OAR
• This OAR is calculated in much the same way as shown in the formula above except the budgeted overhead amount of the department is used instead of the entire overheads
• For example a machining department might use a machine hour based OAR i.e. the number of machine hours it took to make the product
• A labour intensive department might use a labour hours OAR
• Other businesses might just use a factory wide OAR
• The OAR is then used to assign costs to the various products
• The business of OARs can be confusing in theory but can be easily explained using examples please use the links below to access more notes and examples

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