Overhead Absorption Rate OAR

The Overhead Absorption Rate (OAR) is used in cost accounting to allocate overhead costs to products or jobs based on a chosen activity base.

The formula is:

Where the activity level could be:

• Direct labour hours
• Machine hours
• Direct labour cost
• Units produced

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Example:

If total budgeted overheads are RM100,000, and budgeted labour hours are 25,000 hours:

So, for every labour hour worked, RM4 of overhead is absorbed into the cost of production. 

Types of OAR & When to Use

1) Blanket (Plant-wide) OAR

What it is: One rate for the whole factory.

Formula:

$$\text{Blanket OAR}=\frac{\text{Total factory OH (budgeted)}}{\text{Total factory activity (budgeted)}}$$

Common bases: Direct labour hours (DLH), machine hours (MH), or direct labour cost.

Use when:

• Small, homogeneous production (similar products/processes).
• Overheads are driven mainly by one dominant factor (e.g., all work is labour-intensive).

Pros: Simple, fast, low admin.
Cons: Risk of distortion if departments differ (labour vs machine intensity, setup complexity, etc.).

Mini-example:
Budgeted OH RM600k; total MH 120k → OAR = RM5/MH.

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2) Departmental OAR

What it is: Different OARs for each production (and sometimes service) department.
Formula (per dept):

$$\text{Dept OAR}=\frac{\text{Dept OH (budgeted)}}{\text{Dept activity (budgeted)}}$$

Common bases:

• Machining dept: MH
• Assembly dept: DLH
• Finishing/QA: Inspection hours or DLH

Use when:

• Departments have different cost structures and activity drivers.
• Product flows through multiple departments with varying resource intensity.

Pros: More accurate than blanket rates; matches cost behaviour by area.
Cons: More data and admin; still volume-based, so some distortion may remain.

Mini-example:
Machining OH RM300k / 50k MH → RM6/MH; Assembly OH RM200k / 40k DLH → RM5/DLH.

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3) Cost Centre / Operation-Specific OAR (Multiple Rates)

What it is: Finer granularity than departmental—rates by work centre, machine group, or operation.
Use when:

• Significant intra-department variation (e.g., CNC vs manual lathe cells).
• High product diversity and route-specific resource use.

Pros: Highest precision within volume-based methods.
Cons: Data-heavy; requires robust routing/time data.

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4) Activity-Based Absorption (ABC Driver Rates)*

What it is: Absorb OH using activity drivers (setups, material moves, orders, inspections).
Formula (per activity):

$$\text{Activity rate}=\frac{\text{Activity pool OH}}{\text{Total driver quantity}}$$

Use when:

• Overheads are driven by non-volume factors (complexity, batch/product sustaining work).
• Product mix is diverse (low-volume/custom jobs alongside high-volume simples).

Pros: Best cause-and-effect accuracy; reveals cross-subsidies.
Cons: More complex to build/maintain.

*Technically ABC uses “driver rates” rather than traditional OARs, but in practice they play the same role: assigning OH to cost objects.

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5) Service Department Rates (for Reapportionment)

What it is: Rates for service areas (maintenance, stores, canteen) used to reapportion their OH to production cost centres—then those centres apply their OARs.

Use when: Service usage differs materially across departments (e.g., maintenance hours by dept).

Pros: Fairer spread of common support costs.

Cons: Extra step; basis choice matters (e.g., maintenance hours, #requisitions).

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Choosing the Absorption Base (Quick Rules)

• Labour-intensive dept: Use DLH or DL cost.
• Machine-intensive dept: Use MH.
• Setup-driven overheads: Use # of setups or setup hours (ABC style)
• Material-handling-driven: Use # of moves or kg/tons handled (ABC style).
• Quality/inspection costs: Use inspection hours/occurrences (ABC style).
• Facility-sustaining (e.g., HQ rent): Avoid forcing to units; disclose separately or allocate cautiously.

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Predetermined vs Actual Rates (when setting OAR)

• Predetermined (Budgeted) OAR = Budgeted OH ÷ Budgeted activity

  • Use: Planning, standard costing, and timely costing during the period.
  • Leads to under/over-absorption that you reconcile at period end.

• Actual OAR = Actual OH ÷ Actual activity

• • Use: Ex-post analysis; not practical for real-time pricing/costing.

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Quick “Which One Should I Use?” Cheats

• Small, simple plant → Blanket OAR.
• Different departments (machining vs assembly) → Departmental OAR.
• Different cells inside departments → Cost-centre/operation OAR.
• Complexity & batch effects dominate → ABC driver rates.
• Heavy support functions used unevenly → Reapportion service dept costs first.