Overheads absorption rate (OAR) is a pre-determined rate used for absorbing the production overheads into the cost of a product. The following bases can be used for the absorption of overheads into the cost of a product:
- Production volume (units)
- Labour hours (for labor-intensive production)
- Machine hours (for machine intensive production)
- Percentage of direct material cost
- Percentage of direct labour cost
- Percentage of prime cost
Formula – Overheads absorption rate
The formula to calculate the OAR, using number of units produced as a basis, is:
Overhead Absorption Rate (OAR) = Budgeted Overheads ($) / Budgeted Production (Units)
Overheads Absorption Rate (OAR) – Explained
Management estimates the total overheads to be incurred before a budget period. This is done to calculate the cost of producing the product and ultimately the selling price of a product, and to see if the product is viable for the business. Some examples of overheads include light and heat, power, water rates, insurance cost, rent of factory, wages and salaries of indirect workers, indirect material cost, etc. These overheads are then allocated, apportioned, and reapportioned between relative cost centers. Afterwards, these overheads are absorbed into the cost of a product using different absorption bases (as discussed above).
Calculation of OAR – Single Cost Center
Let us take the example of Blue World Limited, a bottle manufacturing company. For the upcoming month, the company plans to produce 10,000 bottles. Management wants to absorb overheads based on production units. The total overheads amount to $50,000. The following information has been provided to you by the management of Blue World Limited:
| $ | |
| Direct Material Cost per unit | 10 |
| Direct Labour Cost per unit | 7 |
| Direct Expenses per unit | 3 |
| Prime Cost per unit | 20 |
A profit mark-up of 20% is to be added to the total cost of the product to arrive at the selling price of the product.
The total cost of the product is the sum of prime cost and overheads cost. Now, we need to calculate the overhead cost to include it in the prime cost of the bottle. We can do this by using the OAR formula as follows:
OAR = Budgeted Overheads ($) / Budgeted Production (Units)
OAR = $50,000 / 10,000 units
OAR = $5 per unit
Therefore:
| $ | |
| Direct Material Cost per unit | 10 |
| Direct Labour Cost per unit | 7 |
| Direct Expenses per unit | 3 |
| Prime Cost per unit | 20 |
| Overheads | 5 |
| Total Cost | 25 |
| Profit (20% of $25) | 5 |
| Selling Price | 30 |
This was a very basic example of absorbing overheads into the cost of products. However, there can be multiple cost centers within a business through which the products pass before completion.
Calculation of OAR – Multiple Cost Centers
In that case, there are two methods to absorb the overheads into the cost of the product. These are:
- Using a Blanket OAR
- Using a Separate OAR for each cost center
Blanket OAR is the overall OAR of the factory. It is calculated by adding the overheads and absorption bases of all cost centers and putting them in the OAR formula. It is also called single factory-wide OAR. It is useful when all the cost centers use the same basis of absorption. However, when cost centers use different bases, separate OAR for each cost center should be used.
To understand this, let us take an example of Timeless Limited, a watch manufacturing Company.
Example – Overheads Absorption Rate (OAR)
The company currently produces two types of watches, T-Men and E-Women. There are two production cost centers in the business, machining and assembly. The management has provided you with the following information:
| Units | Machining | Assembly | |
| T-Men | 3,000 | 2 hours | 1 hour |
| E-Women | 2,000 | 2 hours | 3 hours |
Budgeted overheads for each department are:
| Machining | Assembly | |
| Budgeted Overheads | $100,000 | $135,000 |
Management wants to calculate a blanket OAR and a separate OAR for each product using a suitable basis.
Using Blanket OAR
As we discussed above, a blanket OAR is calculated after taking the total of overheads and absorption basis so:
Total Overheads = $100,000 (machining) + $135,000 (assembly)
Total Overheads = $235,000
Total Hours in each department (Basis of absorption):
- Machining = (3,000 units * 2 hours) + (2,000 units * 2 hours) = 10,000 hours
- Assembly = (3,000 units * 1 hours) + (2,000 units * 3 hours) = 9,000 hours
Total hours = 19,000 hours
Using the OAR formula:
OAR = Budgeted Overheads ($) / Total Budgeted Hours
OAR = $250,000 / 19,000 hours
OAR = $12.37 per machine hour
Using Separate OARs
The total overheads apportioned to the Machining Department are $100,000 and the total hours of the machining department are 10,000 hours, so OAR for Machining Department is:
OAR = Budgeted Overheads ($) / Total Budgeted Hours
OAR = $100,000 / 10,000 hours
OAR = $10 per machine hour
The total overheads apportioned to the Assembly Department are $135,000 and the total hours of the machining department are 9,000 hours, so OAR for Assembly Department is:
OAR = Budgeted Overheads ($) / Total Budgeted Hours
OAR = $135,000 / 9,000 hours
OAR = $15 per machine hour
Now, if we were to calculate the total overheads to be absorbed in both products, we would calculate this as follows:
T-Men
Product T-Men passes through two departments, machining and assembly. The overhead absorption rate of the machining department is $10 per hour and the product T-Men spends 2 hours in the machining department.
Similarly, the OAR of the assembly department is $15 per hour and the product T-Men spends 1 hour in the assembly department. Therefore, the total overheads absorbed by product T-Men are:
Overheads Absorbed – T-MEN = ($10 per hours x 2 hours) + ($15 per hour x 1 hours)
Overheads Absorbed – T-MEN = $35
E-Women
Product E-Women passes through two departments, machining and assembly. The overhead absorption rate of the machining department is $10 per hour and the product E-Women spends 2 hours in the machining department.
Similarly, the OAR of the assembly department is $15 per hour and the product E-Women spends 3 hours in the assembly department. Therefore, the total overheads absorbed by product E-Women are:
Overheads Absorbed – E-Women = ($10 per hours x 2 hours) + ($15 per hour x 3 hours)
Overheads Absorbed – E-Women = $65