Absorption Costing

NotesQuizObjective Test

Absorption Costing

Under absorption costing, fixed overheads are dealt with by calculating a budgeted overhead absorption rate (OAR).

The Overhead Absorption Rate (OAR)

OAR = Budgeted overheads  / Budgeted level of activity

The following can be used as the basis to absorb overheads:

  1. number of units

  2. labour hours

  3. machine hours

Illustration 1

The Company produces product A only.

Product A takes 100 machine hours to produce.

Budgeted overheads are $100,000.

Required:
Calculate the OAR.

  • Solution:

    Budgeted overheads are $100,000.
    Budgeted machine hours for the period were 100.

    OAR = $100,000 / 100 machine hours
    OAR = $1,000 per machine hour

Illustration 2

The Company produces product A and B.

Product A takes 60 machine hours to produce.
Product B takes 40 machine hours to produce.

Budgeted overheads are $100,000.

Required:
Calculate the OAR.

  • Solution:

    Budgeted overheads are $100,000.
    Budgeted machine hours for the period were 60 + 40 = 100.

    OAR = $100,000 / 100 machine hours
    OAR = $1,000 per machine hour

    Therefore, Product A will absorb $1,000 x 60  = $60,000
    Product B will absorb $1,000 x 40 = $40,000

NotesQuizObjective Test