Cambrige AS and A Level Accounting Notes (9706)/ ZIMSEC  Advanced Accounting Level Notes: Absorption Costing:  Overhead 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
OverheadBasis of apportionmentAssembly
Indirect materials
Machine depreciation
Indirect labour
  • 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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