The Overhead Absorption Rate (OAR) is the calculated amount of manufacturing overhead cost applied to a product unit or operating activity to ensure indirect costs can be paid from Gross Profit.
Primary Implication
Your Gross Profit either covers your Fixed Costs or it doesn’t. You are 100% guaranteed a loss whenever it doesn’t unless you have enough Other Income to cover the shortfall or can talk those you pay money to not charge you for their products and services.
You protect yourself from losing money by maximizing your Gross Profit while keeping your Fixed Costs within an acceptable range of what your business can afford. Business Owners who allow their Fixed Costs to increase unchecked are the same people who wonder why they never have any money in the bank.
Overview
Understanding Overhead: Why It Matters to Your Bottom Line
Running a successful business means more than just selling things for more than they cost to make. You also have to cover all those behind-the-scenes expenses that keep your operation running smoothly. This is where understanding your Overhead Absorption Rate (OAR) becomes crucial.
What is OAR?
Think of it like this:
- Direct costs are like the ingredients in a cake – the flour, sugar, eggs that go directly into the final product.
- Indirect costs (overhead) are like your kitchen, oven, and electricity – essential for baking but not directly part of the cake itself.
OAR helps you figure out how much of those “kitchen expenses” should be included in the price of each cake you sell. This ensures you’re not just covering the cost of ingredients but also contributing to those bigger operational expenses.
How is OAR calculated?
OAR = Total Fixed Costs / Total Variable Costs
Why is OAR important?
- Pricing Power: OAR helps you price your products or services profitably. Ignoring overhead can lead to selling at a loss without even realizing it!
- Profitability: By understanding your OAR and managing your overhead, you can free up more money to reinvest in your business or increase your profits.
Lower Overhead = More Opportunity
The less you spend on fixed costs, the less pressure you have to generate revenue just to keep the lights on. This gives you more flexibility to invest in growth, weather economic downturns, and seize new opportunities.
Higher Overhead = Increased Risk
High fixed costs mean you need to sell more just to break even. This increases your risk if sales slow down or if you’re not operating as efficiently as possible.
Here’s a simple example:
Imagine your fixed costs (rent, utilities, etc. ) are $1,200 a day, and your variable costs (materials, labor) are $1,800. To break even, you need to make $3,000 a day.
If you can cut your fixed costs by just $200, you suddenly have an extra $200 each day toward profit. Over a year, that’s a significant boost!
Key takeaway: OAR is a powerful tool for understanding your business costs and making informed pricing decisions that drive profitability.