How to Calculate Overhead Absorption Rate
What is Overhead Absorption Rate?
The overhead absorption rate is the process of allocating indirect costs to products or services, to provide a more complete picture of the overall cost of that product or service.
Indirect costs, often referred to as overheads, include costs such as rent, utilities, administrative salaries, and other shared resources that cannot be directly connected to a specific product or service.
While direct costs, such as raw materials and direct labour, can be easily attributed to a specific product or service, accurately allocating indirect costs is much more difficult as these costs are shared across multiple products, services, or departments.
Overhead Absorption Rate Formula
The formula for calculating the overhead absorption rate is:
Overhead Absorption Rate = Total Budgeted Overheads / Total Budgeted Activity Level
Where:
Total Budgeted Overheads = expected overhead spend
Total Budgeted Activity Level = expected number of units produced/services provided
Example Calculation
Assume a manufacturing company estimates total overhead costs for the year will be £300,000 and expects to produce 100,000 units.
Overhead Absorption Rate = Total Budgeted Overheads / Total Budgeted Activity Level
£300,000 / 100,000 units = £3 per unit.
Therefore, the company must consider this £3 into their pricing strategy alongside any other variable or fixed costs.
Why is Overhead Absorption Rate Important?
Accurate Costing and Pricing
The overhead absorption rate helps to allocate indirect costs to products or services, which provides a more accurate reflection of their true costs.
This accuracy is essential for businesses to set appropriate selling prices and make informed decisions about the profitability of their offerings.
Budgeting and Planning
A reliable overhead absorption rate is crucial for budgeting purposes as it helps businesses forecast costs more accurately.
Using our example from above, if the variable and fixed costs per unit was £10, but the business omitted the £3 per unit overhead costs, they would be spending more than anticipated, which may lead to financial troubles.
Accurate overhead absorption rates also contribute towards informed strategic decision making such as product discontinuation, process improvements or investment decisions.
Performance Evaluation
The overhead absorption rate enables businesses to evaluate their performance by comparing actual costs against budgeted costs.
This helps in identifying areas where overhead costs can be controlled, reduced, or better managed.
Continuing on with our example from above, if the business forecasts an overhead absorption rate of £3 per unit, then management have a specific target to strive for improvement, and could look into measures to improve this number to £2.80 per unit for example.
Cost negotiations with suppliers, energy saving products and investment in more efficient technology could all be avenues to explore.