Planning and control are the backbones of any cost accounting system. It provides the foundation through which management can devise strategies to better perform in the coming periods and increase performance and profitability. In order to better plan, a pre-determined overhead rate is calculated at the start of the year. This rate is also called budgeted overhead absorption rate (OAR).
Formula
OAR = Budgeted indirect cost/ overheads / budgeted output (activity) level
Example Question:
Ambala sweet manufactures bakery products. It has two departments, one is preparation department while the other one is the baking department. Total overhead of the Ambala is 100,000$ and $120,000 for preparation department & for baking department respectively. The preparation department work is mostly labour intensive and involves manual work. On the other hand, baking department work is mostly done via machines. The total labour hours in preparation and baking departments are 25,000 hours and 5,000 hours, while the machine hours are 5,000 and 30,000 respectively. Calculate OAR for both departments.
Solution/ Answer
As preparation department is mostly labour intensive, we will base our overhead absorption rate over the labour hours. However, for the baking department, we will use machine hours for OAR as follows:
OAR – Preparation department = Overheads / labour hours = 100,000 / 25,000 = $4 per labour hour
OAR – Baking department = Overheads / machine hours = 120,000 / 30,000 = $4 per machine hour.
