Applied overhead

Applied overhead is the amount of manufacturing overhead allocated to products. In turn, the overhead is an indirect cost that cannot be physically or economically assigned to individual items. During in a production process some costs can't be traced back to a product, but they should be included in the cost of goods produced for the units manufactured at a certain time.Calculation of what amount overhead cost should be applied to some product is much more difficult than determination of direct cost. In such cases costs are divided according to formulas created in the company.

Accounting for applied overhead

Discussing applied overhead, it should be mentioned that it's one of two types of overhead. We distinguish also actual overhead, which are tracked throughout the year in the overhead account. In this case overhead applied to production is computed throughout the year and is added to actual direct materials and actual direct labor to get total product cost. They require to reconcile any difference between actual and applied overhead and also correct the cost of goods sold account to reflect actual overhead spending. It must be done at the end of the year.

Overhead is applied based on a predetermined formula. To put into the appropriate basis for making this allocation requires a considerable thought. The overhead account isn't a typical account, because it doesn't represent an asset, liability, expense and any other element of financial statement. Amounts go into this account, but then they are transferred out to the other accounts. Actual overhead goes in and then applied overhead goes out. When overhead is applied to production, they are booked on the debit side. In turn if the actual amounts being spent on overhead, they are presented on the debits.

Example of reconciliation applied overhead

At the beginning of the year some company estimated the following:

• Overhead: 360 000
• Direct labor cost: 720 000

This company like most other firms use normal costing and applies overhead on the basis of direct labor cost. For the month of March, direct labor cost was 56 000 $.

Steps by calculate applied overhead

First step

• Add up total overhead, which are estimated indirect materials, indirect labor and also other costs that are not in the direct materials and direct labor. Overhead includes fixed and variable overhead.In this example the company has determined its own overhead on 360 000.

Second step.

• Compute the overhead allocation rate. This predetermined overhead rate must be used to assign overhead to units or services produced
• Pretermined overhead rate = total overhead / direct labor cost
• Pretermined overhead rate is: 360 000 / 720 000 = 0,50, or 50 percent of direct labor cost.

Third step

• Apply overhead. Multiply the overhead allocation rate by the number of direct labor needed to make each goods.
• Overhead applied = pretermined overhead rate x direct labor cost in the analyzed period
• Applied overhead in the March is: 0,50 x 56 000 = 28 000.

Advantages of Applied overhead

Applied overhead has several advantages. To start with, it allows businesses to accurately account for all their costs by assigning a portion of their overhead costs to each product they sell. This helps businesses to make informed pricing decisions and ensure that they are generating enough revenue to cover all their costs. Additionally, it helps to ensure that businesses are accurately capturing their true costs and are not under - or over-charging their customers. Furthermore, it helps businesses to accurately assess the performance of their products and determine which products are generating the most profit. Finally, it helps to ensure that businesses are using their resources efficiently and are not overspending on certain products or services.

Limitations of Applied overhead

Applied overhead has several limitations:

• It is often difficult to accurately determine the amount of overhead to be applied to a product. As overhead is not directly related to the production process, it can be difficult to allocate it accurately and fairly.
• It can be difficult to accurately measure the actual overhead costs. As overhead costs are not incurred directly related to production, they can be hard to identify and measure.
• Due to the complexity of the calculation, applied overhead can be time consuming and difficult to manage.
• Applied overhead can lead to manipulation of costs, as it is possible to allocate more or less overhead to different products.
• Applied overhead can be inflexible and not responsive to changes in the production process. In some cases, the overhead allocated may not be responsive to changes in the production process, leading to inaccurate estimates of costs.

Other approaches related to Applied overhead

An introduction to the other approaches related to applied overhead is that these approaches are used to distribute overhead costs to goods and services produced. Some of the approaches include:

• Activity-based costing (ABC): This approach assigns overhead costs to activities based on the resources used to complete the activity. This approach is useful in providing more accurate cost information on specific products.
• Standard costing: This approach is used to assign overhead costs to the standard costs of products. The overhead costs are based on the company’s expected overhead costs for the production period.
• Allocation based on labor: This approach assigns overhead costs based on the amount of labor used in the production process.

In summary, there are several approaches to applied overhead, including activity-based costing, standard costing, and allocation based on labor. Each approach has its advantages and disadvantages, and the company should select the most suitable approach for their cost accounting system.

Footnotes

Applied overhead — recommended articles

Weighted average method — Contract costing — Absorbed costs — Cost per unit — Underapplied Overhead — Conversion cost — Actual cost — Differential costing — Segment margin

References

• Davis C., Davis E. (2012), Managerial Acoounting, John Wiley and Sons
• Heitger D., Mowen M., Hansen D. (2008), Fundamental Cornerstones of Managerial Accounting, CGS Book Services, CGS Book Services
• Heitger D., Mowen M., Hansen D. (2018), Managerial Accounting, the cornerstone of business decision making, Cengage Learning
• Walther L., Skousen C. (2009), Managerial and Cost Accounting, Christopher J. Skousen and Ventus Publishing

Author: Sławomir Maciejowski