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

To access more topics go the ZIMSEC Advanced Level Accounting page

To access more topics go to the Cambridge AS/A level page

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