Overhead Absorption Rates: A Clear Guide

Overhead Absorption Rates: A Clear Guide

Overhead Absorption Rate (OAR) is a method used to allocate and apportion indirect costs to cost centres and ultimately, to cost units. It provides a fair and logical way to share out overheads, like rent or electricity, across different products or services.

Why this actually matters

You have limited time and a huge syllabus. Focusing on core mechanics like the OAR is crucial because it's a building block for more complex topics like Activity Based Costing, and a guaranteed area for marks on the exam.

Structured breakdown

Calculating the Overhead Absorption Rate involves a clear, multi-step process. Following this structure is the most reliable way to get the calculation right under exam pressure.

1. Step 1: Allocation of overheads. Assign overheads that are directly attributable to a specific cost centre. For example, the salary of a production supervisor is allocated directly to the production department.
2. Step 2: Apportionment of overheads. Share common overheads (like factory rent or electricity) between cost centres using a fair basis. For example, rent might be apportioned based on the floor area each cost centre occupies.
3. Step 3: Reapportionment of service cost centre overheads. Service department costs (like HR or maintenance) must be reapportioned to the production departments because they don't produce output themselves. The two main methods are the direct method and the step-down method.
4. Step 4: Select an absorption basis. Choose a logical basis for absorbing overheads into cost units. Common bases include machine hours, labour hours, or units produced.
5. Step 5: Calculate the Overhead Absorption Rate (OAR). Use the formula: OAR = Total Budgeted Production Overheads / Total Budgeted Absorption Basis.
6. Step 6: Absorb the overhead. Apply the OAR to the actual activity level of each cost unit to charge overheads to production. This is done by multiplying the OAR by the actual number of machine hours, labour hours, etc.
7. Step 7: Calculate under or over-absorption. At the end of the period, compare the total overhead absorbed with the actual overheads incurred. The difference is the under or over-absorption of overheads, which is then written off to the profit and loss account.

Worked example

A company has two production departments, Machining and Assembly, and one service department, Canteen. Budgeted overhead costs and activity levels for the period are as follows:

Budgeted Overheads:

• Machining: $150,000
• Assembly: $80,000
• Canteen: $40,000
• Factory Rent (common cost): $50,000

Additional Information:

• Floor Area: Machining 3,000 sq m, Assembly 2,000 sq m, Canteen 1,000 sq m.
• Canteen costs are reapportioned based on the number of employees: Machining 60, Assembly 40.
• Absorption basis: Machine hours for Machining, Labour hours for Assembly.
• Budgeted activity: Machining 10,000 machine hours, Assembly 5,000 labour hours.

Required: Calculate the OAR for each production department.

Workings:

Step 1 & 2: Apportion Factory Rent

• Total floor area = 3,000 + 2,000 + 1,000 = 6,000 sq m
• Machining rent share: ($50,000 / 6,000) * 3,000 = $25,000
• Assembly rent share: ($50,000 / 6,000) * 2,000 = $16,667
• Canteen rent share: ($50,000 / 6,000) * 1,000 = $8,333

Total Overheads before reapportionment:

• Machining: $150,000 + $25,000 = $175,000
• Assembly: $80,000 + $16,667 = $96,667
• Canteen: $40,000 + $8,333 = $48,333

Step 3: Reapportion Canteen Costs

• Total employees in production = 60 + 40 = 100
• Machining share of Canteen costs: ($48,333 / 100) * 60 = $28,999.80
• Assembly share of Canteen costs: ($48,333 / 100) * 40 = $19,333.20

Total Production Overheads:

• Machining: $175,000 + $28,999.80 = $203,999.80
• Assembly: $96,667 + $19,333.20 = $116,000.20

Step 5: Calculate OAR

• Machining OAR: $203,999.80 / 10,000 machine hours = $20.40 per machine hour
• Assembly OAR: $116,000.20 / 5,000 labour hours = $23.20 per labour hour

Marking Logic:

• Marks are awarded for each logical step.
• 1 mark for correctly apportioning the rent.
• 1-2 marks for calculating the total overhead for each department before reapportionment.
• 1-2 marks for correctly reapportioning the service department costs.
• 1 mark for calculating the final OAR for each production department. Showing your workings clearly is essential.

If you're working full-time

Don't try to master this entire topic in one evening. Focus on one part of the process. For example, spend 30-45 minutes this evening just on reapportioning service centre costs using the direct method. Tomorrow, practice the step-down method. Breaking it down into 30-minute, single-focus sessions prevents burnout and builds confidence methodically.

Common mistakes

• Using the wrong apportionment basis for a common cost.
• Forgetting to reapportion service department costs to production departments.
• Dividing by the wrong activity level when calculating the OAR.
• Confusing budgeted costs/activity with actual costs/activity.
• Using a single, factory-wide OAR when departmental rates are clearly required.
• Making a calculation error and not showing workings, losing all potential follow-through marks.
• Wasting time trying to find a "perfect" apportionment basis when the question provides a clear one.

How examiners think

Examiners are testing a process, not just a final number. They want to see if you can follow a logical, structured method from start to finish. A perfect final OAR is great, but most marks are in the intermediate steps: apportionment, reapportionment, and selecting the correct formula. If you make a calculation error early on but continue to use the incorrect number logically through the remaining steps, you will still earn "own figure" marks. Therefore, always show your workings clearly, step-by-step. Do not just write a final answer.

FAQ

Calm summary

This week, focus on mastering the 5-step OAR process. Do not get overwhelmed by under/over absorption yet. Your next concrete step is to take the worked example above, close your notes, and replicate the calculation on a fresh sheet of paper. Check if your final OARs match. This single action will build more certainty than passively re-reading the textbook.