Question 1

Why do we use a predetermined OAR based on budgets instead of just using actual overheads at the end of the period?

Accepted Answer

A predetermined OAR is used to provide a consistent and timely cost per unit throughout the accounting period. Waiting until the end of the period to know the actual costs would delay crucial business decisions like setting selling prices, valuing inventory, and preparing interim reports. Using a budgeted rate also smooths out month-to-month fluctuations in overhead spending and production volume, providing a more stable unit cost.

Question 2

If a company has both machine-intensive and labour-intensive departments, should it use a single factory-wide OAR?

Accepted Answer

No, this is generally inaccurate and not recommended. Using a single, factory-wide OAR can lead to significant product costing errors. A machine-intensive department's overheads are driven by machine usage, so a machine-hour rate is most appropriate. A labour-intensive department's overheads are better absorbed using a direct labour-hour rate. Using separate departmental OARs provides a more accurate allocation of overheads and therefore a fairer and more realistic product cost.

Question 3

Does under-absorption of overheads automatically mean the business has been inefficient?

Accepted Answer

Not necessarily. Under-absorption can be caused by two main factors: 1) The actual overhead spending was higher than budgeted (an expenditure variance), which could indicate inefficiency or unexpected cost increases. 2) The actual activity level was lower than budgeted (a volume variance), which might be due to lower-than-expected sales demand rather than production inefficiency. It is crucial to analyse the reasons for the under-absorption before drawing conclusions about performance.

Absorption costing

What you need to know

Absorption costing