What is Overhead Absorption Rate?
The overhead absorption rate is the predetermined rate used to assign manufacturing overhead to each unit of production. It equals total estimated overhead divided by the chosen activity base — labor hours, machine hours, or production units.
How It Works
- Set at the start of the period using budgeted overhead and budgeted activity
- Each unit picks up overhead = absorption rate × activity used by that unit
- At period end, actual vs absorbed is compared; the difference is over- or under-absorbed overhead
- Over-absorbed → credit to COGS; under-absorbed → debit to COGS or split with inventory and WIP
- Choice of base matters: heavily automated plants pick machine hours, labor-intensive plants pick labor hours
Saudi Context
Saudi manufacturers running IFRS-aligned cost accounting set absorption rates annually based on practical capacity. SOCPA inspection of cost systems often focuses on this calculation because it directly affects reported inventory and COGS.
Example
A Saudi plastics factory budgets SAR 12M overhead and 100,000 machine hours. Absorption rate = SAR 120/machine hour. Each product absorbs SAR 120 × the machine hours it uses. Actual overhead for the year is SAR 12.6M and actual hours are 95,000 → absorbed = SAR 11.4M → under-absorbed by SAR 1.2M, expensed in COGS.