Overhead absorption rate (oar): methods; absorption; over and under absorption; terms used in absorption; reasons for over and under absorption and examples

The following are the diverse methods used in absorption of overhead costs. They are summarized as shown in this Table

1.1 Example 1

The following information is availed to you to determine the relevant Overhead Absorption Rates (OAR) for ABC Company limited.

Required

i). Calculate six overhead absorption rates

Example 2

XYZ co ltd provided you with the following information in relation to its production activities.

Required

i). Determine the total cost of Big M Production Department using the five (i.e., i-v) different methods of overhead absorption rates.

Solution

Workings

W-1 Computation of Overhead Absorption Rate (OAR)

1.2 Over and Under Absorption of Overhead Cost

Computation of Overhead Absorption Rate (OAR) is a predetermined concept which implies that at the end of it all, there are two values to compare at the end of the set time period. That is at the end of the set duration, the predetermined overhead cost for a unit of a product to be produced using the OAR and the actual overhead cost paid by the firm to produce a unit of a product when production has taken place need to be evaluated to make a decision. So, the concept of absorption, over absorption and under absorption need to be incorporated in decision making.

Terms used in over and under absorption

2.1 Absorption

Definition-1: The term absorption in Cost Accounting means estimation of the overhead cost to be incurred by a business or department in the future when production take place. It is a process that involves use of a predetermined overhead absorption rate to compute or set empirically the total overhead cost expected to be incurred by a production department (see previous definition).

2.2 Over Absorption

Definition 2: The term over-absorption refers to a case where the actual amount of overhead cost of a department or organization is less than the absorbed (i.e., estimated) overhead cost. In such a situation, it implies that the budgeted overhead cost is more than the actual overhead cost and therefore, the excess amount is subtracted from the total cost so as to establish the correct profit.

2.3 Under-Absorption

Definition 3: The term Under-Absorption refers to a case where the actual amount of overhead cost of a department or organization is more than the absorbed (i.e., estimated) overhead cost. In such a situation, it implies that the budgeted overhead cost was found to be less than the actual overhead cost and therefore, the shortage amount is added to the total cost so as to establish the correct profit.

2.4 Example 

Excellence care co. ltd is a pharmaceutical firm that manufacture medicine. Department A produces capsules for increasing human beings’ appetite and department B manufacture a certain kind of mouth wash. The organization relies on estimated overhead absorption rate (OAR) to set the budget as supposedly. Department A is allocated overhead cost based on the direct labor hours while department B is allocated overhead cost using machine hours. The senior accountant is of the opinion that an overhead/estimated absorption rate should be set to enable allocation of overhead cost at the end of the year. The following cost accounting information was made available to you as indicated below;

Required

i). Calculate the overhead absorption rates for each department

ii). Prepare a cost statement for the project assignment for Moses Maxwell, the firm’s client and show the price to be charged to this customer.

iii). Calculate the amount of under or over absorption of overhead for each department

Solution

i). To calculate the overhead absorption rates for each department

Department A

With department A, the base used is the direct labor hours for the activity. Therefore;

Working (W)

Estimated cost per direct labor hour (these 20 values in red color) for Moses Maxwell project

Reasons for over or under absorption of overhead costs

The reasons for over or under absorption of overheads are as follows.

1. The actual hours worked is either less or more than the budgeted hours.
2. The actual overhead costs are different from planned overheads.
3. Both actual overhead costs and actual activity level are dissimilar from the planned costs and level.
4. The technique of overhead absorption may be incorrect.
5. Unforeseen expenditures may be incurred during the accounting period.
6. Extra ordinary expenses might have been included in the calculation of overhead absorption rate.
7. Major changes like standby of manual labor with machines. This leads to increase in capacity levels.