What is Applied Overhead?
Definition: Applied overhead is the amount of indirect costs that can’t be specifically matched to the production of a product but must be assigned to a cost object. In other words, it’s the amount of costs incurred by the company during in a production process that can’t be directly traced back to a specific product or service, but should be included in the cost of goods manufactured for the units produced during the period.
Applied overhead is a type of overhead that is recorded under the cost-accounting method. Applied overhead is a fixed rate charged to a specific production job or department within a company. Applied overhead stands in contrast to general overhead, such as utilities or rent. Other forms of applied overhead include depreciation and insurance.
What Does Applied Overhead Mean?
Cost accountants use this concept to help management estimate the total production costs of a product. Think about it this way. Manufacturing a part requires more than direct labor and direct materials. The machine itself has costs associated with it and the building housing the machine also has a cost. These costs can’t be readily traced back to a single product being produced because they are indirect. Some examples include rent, utilities, insurance, and administrative staff salaries. You can’t trace rent back to a specific product. Instead management must apply these costs to objects in a systematic way.
Overhead application is required to meet certain accounting requirements, but is not needed for most decision-making activities. Applied overhead costs include any cost that cannot be directly assigned to a cost object, such as rent, administrative staff compensation, and insurance. A cost object is an item for which a cost is compiled, such as a product, product line, distribution channel, subsidiary, process, geographic region, or customer.
Overhead is usually applied to cost objects based on a standard methodology that is employed consistently from period to period. For example:
- Apply factory overhead to products based on their use of machine processing time
- Apply corporate overhead to subsidiaries based on the revenue, profit, or asset levels of the subsidiaries
Let’s assume that a company expects to have $800,000 of overhead costs in the upcoming year. It also expects that it will have its normal 16,000 of production machine hours during the upcoming year. As a result, the company will apply, allocate, or assign overhead to the goods manufactured using a predetermined overhead rate of $50 ($800,000 divided by 16,000) for every production machine hour used.
Since the future overhead costs and future number of machine hours were not known with certainty, and since the actual machine hours will not occur uniformly throughout the year, there will always be a difference between the actual overhead costs incurred and the amount of overhead applied to the manufactured goods. Hopefully, the differences will be not be significant at the end of the accounting year.
The Concept of Applied Overhead Costs
The costs of operating a business break down into direct and indirect costs. Direct costs are expenses for acquiring products to sell. In manufacturing, this typically means raw materials and direct labor, while in retail it’s the cost of purchasing goods for resale. Indirect costs are necessary expenditures that aren’t directly related to the production or purchase of goods. These indirect costs are the components of overhead. Because overhead isn’t linked directly to production, a portion of the total overhead cost must be allocated and applied to each unit of production.
For instance, property taxes are one overhead item. However, there’s no specific amount of property tax required to make one unit. The same is true of other overhead items like rent, utilities, office expenses and salaries, maintenance and security. Businesses typically use a standardized methodology for allocating and applying overhead costs to individual units of production. In manufacturing, the basis for applying overhead costs is usually direct labor hours or machine hours.
A company may apply overhead costs in other contexts. For example, a large corporation might apply a portion of its headquarters costs to each of several subsidiaries or geographical areas. This is done to satisfy accounting requirements. However, it’s chiefly in manufacturing that allocation is a priority because accurate application of overhead costs is critical to determining the true cost of a product, which is in turn essential for price setting.
The amount of overhead applied is usually based on a standard application rate that is only changed at fairly long intervals. Consequently, the amount of applied overhead may differ from the actual amount of overhead incurred by a business in any individual accounting period. The variance between the two figures is assumed to average out to zero over multiple periods; if not, the overhead application rate is altered to bring it more closely into alignment with actual overhead.
Once assigned to a cost object, assigned overhead is then considered part of the full cost of that cost object. Recording the full cost of a cost object is considered appropriate under the major accounting frameworks, such as Generally Accepted Accounting Principles and International Financial Reporting Standards. Under these frameworks, applied overhead is included in the financial statements of a business.
Applied overhead is not considered appropriate in many decision-making situations. For example, the amount of corporate overhead applied to a subsidiary reduces its profits, even though the activities of the corporate headquarters staff do not assist the subsidiary in earning a higher profit. Similarly, the application of factory overhead to a product may obscure its actual cost for the purposes of establishing a short-term price for a specific customer order. Consequently, applied overhead may be stripped away from a cost object for the purposes of some types of decision making.
Applied Overhead Versus Actual Overhead
So far, everything has been calculated using a predetermined rate to apply manufacturing overhead figures to individual jobs. But what happens when the actual bills start coming in on all those indirect costs? Certainly, the actual overhead, the company’s true indirect manufacturing costs, will not match up to the estimated numbers.
In most manufacturing organizations, the applied overhead is added to the materials and direct labour to calculate the cost of goods sold on every job during a specified period. At the same time, accountants are also recording the actual bills. They keep a running total of these costs and hold them aside for later.
At the end of the accounting period, these actual overhead costs are reconciled with the applied overhead to make sure that the actual overhead costs end up in the cost of goods sold.