In cost accounting, the Overhead Absorption Rate (OAR) is the rate at which overhead costs are applied to the cost of goods or services produced. It’s used to allocate indirect costs (such as rent, utilities, depreciation, and salaries of support staff) to specific products or cost centers. The main purpose is to ensure that all costs, including fixed and variable overheads, are appropriately assigned to products or services.
The formula to calculate the Overhead Absorption Rate is:
Where:
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Total Estimated Overhead Costs refers to the total overhead costs expected to be incurred over a period (usually a year).
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Base is the cost driver used to absorb overhead costs, which could be factors like direct labor hours, machine hours, or units produced.
Normal capacity reflects the expected level of production or activity over a period, accounting for typical variations like seasonal demand, holidays, and regular downtime. It is considered the most practical and realistic base for allocating overhead costs because it smooths out temporary fluctuations in production levels, providing a fair and stable rate for cost absorption.
Example:
If a company estimates its overhead costs to be $100,000 for the year and expects to use 50,000 direct labour hours, the overhead absorption rate would be:
OAR = 100,000 / 50,000 = 2 per labour hour
This means that for every direct labour hour worked, $2 of overhead costs will be absorbed by the product.
Why it’s important:
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Accurate cost allocation: It helps allocate indirect costs fairly to products or services.
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Pricing decisions: It ensures that all costs are considered when pricing products.
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Performance analysis: It provides insights into how efficiently overhead costs are being absorbed relative to production activity.
Different bases for absorption can be used depending on the business’s nature, such as machine hours for a factory setting or labor hours for a service industry.