Overhead Absorption Rate Calculator
Determine how much indirect cost is assigned to each unit of activity.
Understanding the Overhead Absorption Rate (OAR)
The Overhead Absorption Rate (OAR) is a crucial accounting metric used to allocate indirect manufacturing costs—such as factory rent, utilities, and management salaries—to specific products or services. Since these costs cannot be directly traced to a single unit, businesses use a "base" (like labor hours) to distribute them fairly.
How to Calculate OAR
The standard formula for calculating the overhead absorption rate is:
OAR = Total Budgeted Overheads / Total Budgeted Allocation Base
Common Allocation Bases
- Direct Labor Hours: Best for businesses where production is manual and labor-intensive.
- Machine Hours: Ideal for automated factories where machinery is the primary driver of production.
- Units Produced: Used when a company produces a single type of product or very similar items.
- Percentage of Direct Costs: Sometimes overheads are applied as a percentage of the dollar value of labor or materials.
Practical Example
Imagine a furniture factory that budgets $100,000 in overhead costs for the year. They anticipate using 5,000 machine hours to complete their production cycle. To find the OAR:
- Total Overheads: $100,000
- Allocation Base: 5,000 Machine Hours
- Calculation: $100,000 / 5,000 = $20.00 per machine hour
This means for every hour a machine runs to make a chair, $20 of indirect factory cost is "absorbed" by that chair's cost profile.
Why OAR Matters for Pricing
Without an accurate OAR, a business might underestimate the true cost of production, leading to thin profit margins or net losses. By "absorbing" these costs into the product price, management ensures that all operational expenses are covered by sales revenue.