Direct Labor Hours
Machine Hours
Units of Production
Direct Labor Cost ($)
Direct Material Cost ($)
Total estimated hours for the period.
Calculated Absorption Rate
function updateBaseLabel() {
var type = document.getElementById('allocationBaseType').value;
var label = document.getElementById('baseAmountLabel');
var helper = document.getElementById('baseHelperText');
var wrapper = document.getElementById('baseInputWrapper');
// Remove existing currency symbol if present
var existingSymbol = wrapper.querySelector('.currency-symbol');
if (existingSymbol) {
existingSymbol.remove();
}
wrapper.classList.remove('has-currency');
if (type === 'labor_hours') {
label.innerText = 'Total Budgeted Labor Hours';
helper.innerText = 'Total estimated direct labor hours.';
} else if (type === 'machine_hours') {
label.innerText = 'Total Budgeted Machine Hours';
helper.innerText = 'Total estimated machine running hours.';
} else if (type === 'units') {
label.innerText = 'Total Budgeted Units';
helper.innerText = 'Total estimated units to be produced.';
} else if (type === 'labor_cost') {
label.innerText = 'Total Direct Labor Cost';
helper.innerText = 'Total estimated wages for direct labor.';
wrapper.classList.add('has-currency');
wrapper.insertAdjacentHTML('afterbegin', '$');
} else if (type === 'material_cost') {
label.innerText = 'Total Direct Material Cost';
helper.innerText = 'Total estimated cost of raw materials.';
wrapper.classList.add('has-currency');
wrapper.insertAdjacentHTML('afterbegin', '$');
}
}
function calculateOAR() {
var overheads = parseFloat(document.getElementById('totalBudgetedOverheads').value);
var baseAmount = parseFloat(document.getElementById('totalBaseAmount').value);
var baseType = document.getElementById('allocationBaseType').value;
var resultBox = document.getElementById('resultBox');
var resultDisplay = document.getElementById('oarResult');
var descriptionDisplay = document.getElementById('oarDescription');
// Validation
if (isNaN(overheads) || overheads < 0) {
alert("Please enter a valid amount for Total Overheads.");
return;
}
if (isNaN(baseAmount) || baseAmount <= 0) {
alert("Please enter a valid amount for the Allocation Base (must be greater than 0).");
return;
}
var rate = 0;
var formattedResult = "";
var textDesc = "";
// Calculation Logic
if (baseType === 'labor_cost' || baseType === 'material_cost') {
// Percentage basis calculation
rate = (overheads / baseAmount) * 100;
formattedResult = rate.toFixed(2) + "%";
var baseName = (baseType === 'labor_cost') ? "Direct Labor Cost" : "Direct Material Cost";
textDesc = "For every $1.00 spent on " + baseName + ", you should allocate $" + (rate/100).toFixed(2) + " to overheads.";
} else {
// Per unit/hour calculation
rate = overheads / baseAmount;
formattedResult = "$" + rate.toFixed(2);
var unitName = "";
if (baseType === 'labor_hours') unitName = "Direct Labor Hour";
else if (baseType === 'machine_hours') unitName = "Machine Hour";
else if (baseType === 'units') unitName = "Unit Produced";
formattedResult += " per " + unitName;
textDesc = "Every time one " + unitName.toLowerCase() + " is consumed/produced, $" + rate.toFixed(2) + " is applied to the product cost.";
}
// Display Results
resultDisplay.innerText = formattedResult;
descriptionDisplay.innerText = textDesc;
resultBox.style.display = "block";
}
What is Overhead Absorption Rate?
The Overhead Absorption Rate (OAR), also known as the overhead recovery rate, is a method used in management accounting to allocate indirect costs (factory overheads) to specific cost objects, such as products or jobs. Unlike direct costs (raw materials and direct labor), overheads cannot be traced directly to a single unit of production. Therefore, they must be "absorbed" into the cost of the product using a calculated rate based on activity levels.
Calculating the OAR is essential for accurate product costing, setting competitive prices, and valuing inventory correctly on financial statements.
How to Calculate Overhead Absorption Rate
The calculation of OAR is typically done at the beginning of an accounting period using budgeted (estimated) figures. This is known as a predetermined overhead rate. The general formula is:
OAR = Total Budgeted Factory Overheads / Total Budgeted Allocation Base
Components of the Formula:
Total Budgeted Overheads: The sum of all estimated indirect costs for the period (e.g., factory rent, electricity, depreciation of machinery, indirect labor).
Allocation Base: The driver used to assign these costs. This should be the factor that most closely correlates with the incurrence of the overhead costs. Common bases include direct labor hours, machine hours, or direct labor cost.
Choosing the Right Allocation Base
The accuracy of your absorption costing depends heavily on selecting the appropriate allocation base. Here is a guide on when to use which base:
Direct Labor Hours: Best used in labor-intensive environments where manual work drives the overhead costs.
Machine Hours: Ideal for highly automated manufacturing environments where machinery operation is the primary cost driver (e.g., depreciation, power, maintenance).
Units of Production: Useful only when a company produces a single, uniform product type.
Direct Labor Cost (%): Often used when wage rates are uniform, though it can be misleading if high-paid workers don't necessarily incur more overheads.
Example Calculation
Imagine a furniture manufacturing company, "WoodWorks Ltd." They estimate their financials for the upcoming year as follows:
Total Estimated Overheads: $250,000
Total Estimated Machine Hours: 12,500 hours
Using the formula:
$250,000 / 12,500 hours = $20.00 per Machine Hour.
If a specific dining table takes 5 machine hours to produce, the overhead cost absorbed into that table would be 5 hours x $20 = $100.
Why is OAR Important for Business?
1. Pricing Strategy: Without including overheads in your product cost, you might underprice your products and lose money despite covering direct costs.
2. Inventory Valuation: Accounting standards (like GAAP and IFRS) require that inventory valuations include a portion of manufacturing overheads.
3. Performance Analysis: By comparing the absorbed overheads (based on the rate) against the actual overheads incurred, managers can calculate the "Over/Under Absorption" to analyze spending efficiency.