Overhead Absorption Rate
The overhead absorption rate (OAR) is a crucial facet of cost accounting, particularly in absorption costing, where overhead costs are allocated to products or services. The OAR helps capture indirect costs—such as utilities, rent, and salaries of the administrative staff—that are not directly attributable to specific products. This rate ensures that these indirect costs are systematically and fairly distributed across all products or services based on a predefined basis, such as labor hours, machine hours, or direct material cost.
\[
\text{Overhead Absorption Rate (OAR)} = \frac{\text{Total Overhead Costs}}{\text{Total Absorption Basis Units}}
\]
Examples
-
Example 1: Machine Hours Basis
- Total Overhead Costs: $50,000
- Total Machine Hours: 10,000 hours
- OAR Calculation:
\[
OAR = \frac{50,000}{10,000} = $5 \text{ per machine hour}
\]
-
Example 2: Labor Hours Basis
- Total Overhead Costs: $30,000
- Total Labor Hours: 15,000 hours
- OAR Calculation:
\[
OAR = \frac{30,000}{15,000} = $2 \text{ per labor hour}
\]
Frequently Asked Questions
Q1: What is the purpose of the overhead absorption rate?
A1: The purpose is to allocate indirect costs, commonly known as overheads, to specific products or services to achieve a more accurate cost analysis and pricing.
Q2: What are common absorption bases?
A2: Common absorption bases include labor hours, machine hours, direct material cost, and units produced.
Q3: How is OAR used in financial statements?
A3: OAR is used to allocate overheads to production costs in the cost of goods sold (COGS), affecting inventory valuation and the income statement.
- Absorption Costing: A costing method that includes all manufacturing costs—direct materials, direct labor, and both variable and fixed manufacturing overheads—in the cost of a product.
- Overheads: Indirect expenses related to the overall operation of a business, including utilities, rent, and administrative salaries.
- Job Order Costing: A cost tracking system that assigns costs to specific jobs or batches, useful for custom or unique items production.
- Process Costing: A cost tracking system used for standardized products that are produced in continuous processes.
Online References
- Investopedia - Absorption Costing Definition
- CIMA Global - Overhead Absorption Rate
Suggested Books for Further Studies
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan
- “Managerial Accounting” by Ray H. Garrison, Eric W. Noreen, and Peter C. Brewer
- “Introduction to Management Accounting” by Charles T. Horngren, Gary L. Sundem, and William O. Stratton
- “Cost & Effect: Using Integrated Cost Systems to Drive Profitability and Performance” by Robert S. Kaplan and Robin Cooper
Accounting Basics: “Overhead Absorption Rate” Fundamentals Quiz
### How is the Overhead Absorption Rate (OAR) calculated?
- [x] By dividing total overhead costs by total absorption basis units.
- [ ] By adding total production costs.
- [ ] By subtracting total direct labor costs from total overhead costs.
- [ ] By multiplying machine hours by labor hours.
> **Explanation:** The OAR is calculated by dividing the total overhead costs by the total absorption basis units.
### What basis can be used for calculating the Overhead Absorption Rate?
- [ ] Only units produced
- [x] Labor hours, machine hours, or direct material costs
- [ ] Total revenue
- [ ] Sales volume only
> **Explanation:** The OAR can be based on various bases such as labor hours, machine hours, or direct material costs.
### Why is Overhead Absorption Rate important?
- [ ] To reduce the cost of goods sold
- [ ] To lower salaries of administrative staff
- [x] To allocate indirect costs accurately to products or services
- [ ] To increase sales volume
> **Explanation:** OAR is crucial for allocating indirect costs accurately to products or services, ensuring precise cost analysis.
### Can Overhead Absorption Rate impact the income statement?
- [x] Yes, it affects inventory valuation and cost of goods sold.
- [ ] No, it only impacts the balance sheet.
- [ ] Yes, but only in non-manufacturing industries.
- [ ] No, it doesn't impact any financial statements.
> **Explanation:** OAR impacts the income statement through allocation to COGS, affecting inventory valuation.
### If total overhead cost is $40,000 and total machine hours are 8,000, what is the OAR?
- [ ] $8 per machine hour
- [x] $5 per machine hour
- [ ] $6 per machine hour
- [ ] $4 per machine hour
> **Explanation:** OAR = $40,000 / 8,000 = $5 per machine hour.
### Which costing method uses the Overhead Absorption Rate?
- [ ] Direct costing
- [x] Absorption costing
- [ ] Marginal costing
- [ ] Activity-based costing
> **Explanation:** OAR is used in absorption costing to allocate overheads.
### What kind of expenses are overheads?
- [x] Indirect expenses such as utilities and rent
- [ ] Direct labor costs only
- [ ] Direct material costs only
- [ ] Profit margins
> **Explanation:** Overheads include indirect expenses like utilities and rent, not directly tied to specific products.
### What is another name for overhead costs?
- [x] Indirect costs
- [ ] Direct costs
- [ ] Fixed costs only
- [ ] Variable costs only
> **Explanation:** Overhead costs are also referred to as indirect costs.
### How does OAR help in cost accounting?
- [x] By providing a way to allocate overhead costs to products or services
- [ ] By simplifying the tax computation process
- [ ] By reducing direct labor costs
- [ ] By eliminating the need for financial audits
> **Explanation:** OAR helps allocate overhead costs accurately in cost accounting, enhancing cost detail per product or service.
### What is a frequent challenge when using OAR?
- [ ] Simple to compute
- [ ] Requires no additional information
- [x] Accurate basis selection for allocation
- [ ] Only applicable to large corporations
> **Explanation:** Selecting an accurate basis for allocation (e.g., labor hours, machine hours) can be challenging yet is crucial for fair cost distribution.
Thank you for deepening your knowledge on Overhead Absorption Rate! Keep excelling in your financial studies.
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