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Management Accounting · Absorption and marginal costing

Absorption Costing and Overhead Absorption Rates (OAR) Explained

Updated 11 October 2026 · Fact-checked

Absorption costing charges every unit with a share of production overheads. You allocate or apportion overheads to cost centres, then divide the total by an activity base such as labour hours, machine hours or units. That gives the overhead absorption rate (OAR). Multiply the OAR by each unit's activity.

Understand Absorption Costing and Overhead Absorption Rates

Every product needs materials and labour, but it also uses factory rent, power, supervision and machine depreciation. These are production overheads. You cannot trace them to a single unit, yet a full product cost must include them. Absorption costing solves this by sharing overheads across units in a fair, planned way.

There are three stages. Allocation means charging a whole cost to the one cost centre that caused it, for example a supervisor's salary in the assembly department. Apportionment means sharing a cost that benefits several cost centres, using a fair basis such as floor area for rent or asset value for depreciation. Absorption means charging the overheads of each production cost centre to units, using an overhead absorption rate.

Service cost centres, such as the canteen or maintenance, do not make products. Their costs are reapportioned to the production cost centres, so that all overheads end up in the departments that make units. Then each production department gets its own rate.

The rate is set in advance, using budgeted overheads and budgeted activity. You need it before the period ends so you can cost jobs and quote prices. The base should reflect what drives the overhead. Use machine hours in a machine-heavy department, labour hours in a labour-heavy one, and units when all products are identical.

Because the rate uses budgets, actual overheads and actual activity will differ. The difference is over- or under-absorption, which is a separate topic. In absorption costing, closing inventory also carries a share of fixed overheads, which is why profit differs from marginal costing.

Key formulas to remember

Overhead absorption rate (OAR)
OAR = Budgeted overheads ÷ Budgeted activity level
Use the same cost centre for both figures. Activity is labour hours, machine hours or units.
Overhead absorbed
Overhead absorbed = OAR × Actual activity
Use actual hours or units produced, not budgeted ones.
Rate per unit base
Overhead per unit = OAR × hours per unit
Use when the rate is per hour and you need the cost of one unit.
Full production cost per unit
Prime cost + Variable overhead + Absorbed fixed overhead
Prime cost is direct materials plus direct labour plus direct expenses.

How to solve Absorption Costing and Overhead Absorption Rates questions

Use this order for any absorption costing question. It keeps the working tidy and stops you missing a stage.

  1. 1Read what is asked: a rate, an overhead charge per unit, or a full unit cost.
  2. 2List overheads by cost centre. Allocate costs that belong to one centre.
  3. 3Apportion shared costs using the stated bases, such as floor area or number of employees.
  4. 4Reapportion service centre costs to production centres, using the given percentages or usage.
  5. 5Choose the base for each production centre: labour hours, machine hours or units.
  6. 6Calculate OAR = budgeted overheads ÷ budgeted activity for each centre.
  7. 7Multiply the OAR by the hours or units used by the product in that centre.
  8. 8Add the overhead to prime cost for the full unit cost, then check units and rounding.

Quickest way: Rate first, then multiply

When to use it: Use this when the question gives total budgeted overheads and activity, and asks for a rate or a unit cost in a number entry or multiple choice.

  1. Underline budgeted overheads and budgeted activity. Ignore actual figures for the rate.
  2. Divide to get the OAR. Keep full decimals until the end.
  3. Multiply by the hours per unit in the question.
  4. Add direct materials and labour only if full cost is asked.
  5. Compare your answer with the options. Check that the units match, for example $ per hour or $ per unit.

Common mistakes in Absorption Costing and Overhead Absorption Rates

  • Using actual overheads or actual hours to calculate the rate.

    Students see actual figures in the question and assume they are needed.

    Fix: The rate uses budgeted overheads and budgeted activity. Use actual activity only to work out overhead absorbed.

  • Forgetting to reapportion service centre costs.

    Students stop once costs sit in departments and treat the canteen as a final cost centre.

    Fix: Always move service centre costs to production centres before calculating any OAR.

  • Choosing the wrong absorption base.

    Students default to labour hours without reading about the department.

    Fix: Machine-intensive department means machine hours. Labour-intensive means labour hours. Identical units means units.

  • Mixing up allocation and apportionment.

    The words sound alike.

    Fix: Allocation is a whole cost to one centre. Apportionment is sharing a cost across several centres.

  • Adding overhead to the wrong cost, such as including selling costs in the OAR.

    Students include every overhead in the list.

    Fix: Absorption costing for inventory valuation includes production overheads only. Leave out selling, distribution and administration costs unless told otherwise.

  • Applying one factory-wide rate when departments have separate rates.

    Students rush to a single total.

    Fix: If departments are given, calculate a rate for each and apply each to the hours used there.

Worked examples

Example 1

A company budgets production overheads of $240,000 and 30,000 machine hours. Product Z uses 4 machine hours and has direct materials of $18 and direct labour of $12 per unit. Actual output in the period used 31,000 machine hours. Calculate the OAR, the full production cost per unit of Z, and the overhead absorbed in the period.

Show the solution
  1. OAR = budgeted overheads ÷ budgeted machine hours = $240,000 ÷ 30,000 = $8 per machine hour.
  2. Overhead per unit of Z = $8 × 4 hours = $32.
  3. Full cost per unit = $18 + $12 + $32 = $62.
  4. Overhead absorbed = OAR × actual hours = $8 × 31,000 = $248,000.

Answer: OAR is $8 per machine hour, full cost of Z is $62 per unit, and overhead absorbed is $248,000.

Example 2

A factory has two production departments, Cutting and Finishing, and one service department, Stores. Allocated and apportioned overheads are: Cutting $60,000, Finishing $40,000, Stores $20,000. Stores costs are reapportioned 60% to Cutting and 40% to Finishing. Budgeted activity is 12,000 machine hours in Cutting and 9,000 labour hours in Finishing. Calculate the OAR for each department.

Show the solution
  1. Reapportion Stores: Cutting gets 60% × $20,000 = $12,000. Finishing gets 40% × $20,000 = $8,000.
  2. Cutting total overhead = $60,000 + $12,000 = $72,000.
  3. Finishing total overhead = $40,000 + $8,000 = $48,000.
  4. Cutting OAR = $72,000 ÷ 12,000 machine hours = $6 per machine hour.
  5. Finishing OAR = $48,000 ÷ 9,000 labour hours = $5.33 per labour hour, rounded (exactly $16 ÷ 3).

Answer: Cutting is $6 per machine hour and Finishing is $5.33 per labour hour (rounded).

Exam tips

  • Check which activity figure the question calls budgeted. The OAR always uses it.
  • Watch the base. If a question gives both machine hours and labour hours, pick the one linked to the department's main activity.
  • In multiple response questions, a statement saying the OAR is set using actual costs is false. Cross it out quickly.
  • For number entry, keep full decimals in your calculator and round only the final answer to the places requested.
  • Write allocation, apportionment and absorption on your scrap paper as a three-step reminder before service centre questions.

Practice questions from Absorption and marginal costing

Absorption Costing and Overhead Absorption Rates in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Absorption Costing and Overhead Absorption Rates: frequently asked questions

What is the difference between allocation, apportionment and absorption?

Allocation charges a whole cost to one cost centre. Apportionment shares a cost across several cost centres on a fair basis. Absorption then charges the overheads of a production centre to units using the OAR.

How do you calculate the overhead absorption rate?

Divide budgeted overheads for a cost centre by its budgeted activity. The activity can be labour hours, machine hours or units. The answer is a rate, such as $8 per machine hour.

Why is the OAR based on budgeted figures?

You need a rate before the period ends so you can cost products and set prices. Actual figures are only known later. The difference between absorbed and actual overheads is dealt with as over- or under-absorption.

Which absorption base should I choose in the exam?

Choose the base that best reflects how overheads are caused. Use machine hours where machines drive costs, labour hours where labour does, and units where products are identical. The question usually gives a clue.