Overhead Absorption Rates

Once all overheads sit in the production departments (from the previous subtopic), they must be charged onto cost units. This is done with an overhead absorption rate (OAR):

$\text{OAR} = \frac{\text{Budgeted (estimated) overhead}}{\text{Budgeted (estimated) activity}}$

The activity can be measured in:

• machine hours — best for a machine-intensive department;
• direct labour hours — best for a labour-intensive department;
• units of output — only where products are identical.

Example. Budgeted overhead $60,000; budgeted machine hours 15,000 → OAR = 60,000 ÷ 15,000 = $4 per machine hour.

The rate is predetermined — set from budgeted figures before the period begins — so the business can cost and price jobs in advance without waiting for the actual overhead to be known.

To charge overhead onto a unit or job:

$\text{Overhead absorbed} = \text{OAR} \times \text{actual activity (hours/units)}$

Then build the full (absorption) cost:

$\text{Full cost} = \text{Prime cost} + \text{Absorbed overhead}$

Example. A job uses $50 direct materials, $30 direct labour and 5 machine hours. With an OAR of $4 per machine hour:

• Overhead absorbed = 4 × 5 = $20.
• Full cost = (50 + 30) + 20 = $100.

A selling price is then set by adding the required profit margin or mark-up to the full cost. This is why absorption costing is central to job and batch costing and to pricing.

Because the OAR is predetermined from budgets, the overhead absorbed (rate × actual activity) will usually differ from the actual overhead incurred:

$\text{Under/over-absorption} = \text{Overhead absorbed} - \text{Actual overhead}$

• Under-absorption: absorbed < actual → not enough overhead was charged to production → the shortfall is an extra expense (a charge) in the income statement.
• Over-absorption: absorbed > actual → too much overhead was charged → the excess is credited (added back) in the income statement.

Why it happens: the actual overhead differs from budget, and/or the actual activity differs from the budgeted activity used to set the rate.

	Absorbed vs actual	Income statement
Under-absorption	Absorbed < actual	Charged (expense)
Over-absorption	Absorbed > actual	Credited (added back)

The basis of the rate should reflect how the department incurs overhead:

• In a machine-intensive department (much of the overhead is power, machine depreciation and maintenance), a machine-hour rate is most accurate.
• In a labour-intensive department (overhead driven by people and supervision), a labour-hour rate is more accurate.
• A per-unit rate is only fair when all units are identical.

A poorly chosen basis charges overhead unfairly between products, distorting the full cost per unit and so the price. Different departments can use different bases — for example a machine-hour rate in machining and a labour-hour rate in assembly. This need for separate departmental rates, and the use of predetermined figures, are reasons some businesses move to activity-based costing (ABC) for more accurate product costs.