Overhead Absorption Rate (OAR’s) or Overhead Recovery – Definition, Uses and Types:
Actual amount of overheads cannot be accurately determined at the time of producing goods. In order to charge the total costs of the production cost center to the cost units, we need to calculate an overhead absorption rate or overhead recovery for each cost center.
Actual and Predetermined Overhead Absorption Rates:
In most cases overhead absorption rate is calculated prior to accounting period using estimated or budgeted overheads figures for an estimated activity level. This is so as the actual overheads and actual activity level cannot be determined in advance before the end of the period. As a result, the actual overhead absorption rate could not be calculated until the end of the period. This implies that product costs in this case could not be calculated until the end of a period and clearly this would produce unacceptable delays into such procedures as invoicing and estimating. This is such a major advantage that virtually all absorption rates used are predetermined.
Actual VS Predetermined Overhead Absorption Rates:
Because the actual overheads are not known until all cost information have been collected, there may be practical problems in estimating cost of an activity. Many businesses will, therefor, use predetermined overhead absorption rate, estimated at the start of an accounting period. At the end of the period an adjustment is made to bring the predetermined overheads to match with the actual overhead cost.
The use of predetermined overhead absorption rate can cause particular problems where; there is a fixed cost, because the volume of activity for the period ahead has to be estimated as well as the amount of overheads.
Absorption rates which use actual overheads costs and actual activity level are also possible but could suffer from two very serious limitations:
(i) Actual costs and volume may not be determined until the end of the relevant period.
(ii) Actual costs and volume may fluctuate within a particular period.
However these limitations do not make use of actual absorption rate impractical rather it depends on the specific circumstances. If there is no significant difference between estimated and actual costs (which is possible because most of overheads are fixed in nature) and activity levels and if costs and activity occur reasonably evenly throughout the period, then actual absorption rate is possible.
Advantages of using Predetermined Overhead Absorption Rate:
(i) They enables overheads to be absorbed immediately after production.
(ii) They make it easier to estimate total and per unit product or job cost.
(iii) They smooth out uncontrollable fluctuations that would otherwise occur in unit costs if product is uneven.