Overhead Absorption Rate

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.

Formula§

$$\text{Overhead Absorption Rate (OAR)} = \frac{\text{Total Overhead Costs}}{\text{Total Absorption Basis Units}}$$

Examples§

1. Example 1: Machine Hours Basis

   • Total Overhead Costs: $50,000
   • Total Machine Hours: 10,000 hours
   • OAR Calculation: \[ OAR = \frac{50,000}{10,000} = $5 \text{ per machine hour} \]

2. 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.

Related Terms§

• 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§

1. Investopedia - Absorption Costing Definition
2. CIMA Global - Overhead Absorption Rate

Suggested Books for Further Studies§

1. “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan
2. “Managerial Accounting” by Ray H. Garrison, Eric W. Noreen, and Peter C. Brewer
3. “Introduction to Management Accounting” by Charles T. Horngren, Gary L. Sundem, and William O. Stratton
4. “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§

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