Question

How do we calculate an Overhead Absorption Rate?

A. Divide total overhead by total direct costs.
B. Divide total direct costs by total overhead.
C. Exclude overhead from cost calculations.
D. Use a fixed rate for all products.

Answer 1

The Overhead Absorption Rate is calculated by dividing total overhead by total direct costs. The concept of 'spreading the overhead' refers to allocating fixed costs over more units of output, thus reducing the average cost per unit. The average fixed cost curve is a downward-sloping curve that represents this effect.

Step-by-step explanation:

To calculate the Overhead Absorption Rate, the correct method is to divide total overhead by total direct costs. This helps in determining how much overhead should be allocated to each unit of production. While calculating this, businesses often use a metric called average fixed cost, which can be found by dividing the fixed cost, or overhead, by the quantity of output produced.

For example, if the fixed cost is $1,000 and 10 units of a product are made, then the average fixed cost would be $100 per unit. However, if 100 units are produced, the average fixed cost drops to $10 per unit. This depicts the concept of "spreading the overhead", which means allocating the fixed costs over a larger number of units, thereby reducing the cost per unit.

The average fixed cost curve is typically a downward-sloping curve that approaches zero as production increases. This curve visually represents the effect of spreading the overhead across more units and showcases why economies of scale can be advantageous for a company.