What Is Applied Overhead and How Is It Calculated?

Applied overhead is the system businesses use to assign indirect manufacturing costs to the products they create. These indirect costs, known as overhead, include expenses like factory rent and equipment maintenance that are not directly tied to a single product. This process ensures that the total cost of a product reflects not just its direct materials and labor, but also a fair share of these support costs. Accurately assigning these expenses helps determine a product’s true cost, which influences pricing, profitability analysis, and overall financial health.

Calculating the Predetermined Overhead Rate

Because actual overhead costs are not known until a period ends, companies use an estimate, called the predetermined overhead rate, to apply these costs to products. This allows for timely product costing and provides consistency for pricing and profitability analysis. The formula is the Estimated Total Manufacturing Overhead Cost divided by the Estimated Total of the Allocation Base. The numerator is a budget of expected indirect costs, developed by analyzing previous costs and adjusting for anticipated changes.

The denominator, or allocation base, is a measure of activity that drives overhead costs, such as direct labor hours or machine hours. The base should have a strong cause-and-effect relationship with the overhead costs. For instance, if a factory’s overhead is mostly machine depreciation and maintenance, using machine hours as the base is logical. If a company estimates $500,000 in overhead and 25,000 direct labor hours for the year, its predetermined overhead rate would be $20 per direct labor hour.

The Process of Applying Overhead

Once the predetermined overhead rate is established, it is used to assign budgeted overhead costs to individual jobs or products as they are produced. This process connects the estimated overhead costs to the actual work being done.

The calculation is: Applied Overhead equals the Predetermined Overhead Rate multiplied by the Actual Amount of the Allocation Base used by the job. As a product consumes the allocation base, such as machine hours or direct labor hours, the overhead cost is attached to it.

To illustrate, a company with a predetermined overhead rate of $15 per machine hour runs a job that requires 20 machine hours. The overhead applied to this job would be $300 ($15 per hour multiplied by 20 hours). This $300 is then added to the job’s direct material and direct labor costs to determine its total manufacturing cost.

Reconciling Actual vs Applied Overhead

At the end of an accounting period, a company compares its total actual overhead costs with the total overhead it applied to production. Actual overhead is the sum of all real indirect expenses, while applied overhead is the total assigned using the predetermined rate. It is rare for these two totals to be the same, resulting in either underapplied or overapplied overhead.

Underapplied overhead occurs when the applied overhead is less than the actual costs incurred. This means products were not charged enough to cover indirect costs, leading to an understated Cost of Goods Sold (COGS) and an overstated net operating income. For example, if actual overhead was $520,000 and $500,000 was applied, there is a $20,000 underapplied balance.

Conversely, overapplied overhead happens when the applied overhead exceeds the actual costs. This means products were burdened with more cost than necessary, causing COGS to be overstated and net operating income to be understated. If a company with $520,000 in actual overhead had applied $535,000, it would have a $15,000 overapplied overhead balance.

Disposing of Overhead Variances

After identifying an underapplied or overapplied balance, this variance must be disposed of to ensure financial records accurately reflect the period’s costs. The method for this adjustment depends on the significance, or materiality, of the variance amount. The goal is to adjust inventory and cost accounts so they are not misstated by the initial estimation.

The most common approach for an immaterial variance is to close the entire amount directly to the Cost of Goods Sold account. For underapplied overhead, this involves increasing COGS, which reduces net income. For overapplied overhead, the adjustment decreases COGS, thereby increasing net income. This method is favored for its simplicity.

A more complex method is required when the variance is material. This method, known as proration, allocates the overhead variance among the accounts that contain applied overhead: Work-in-Process inventory, Finished Goods inventory, and Cost of Goods Sold. The variance is distributed proportionally based on the applied overhead in each account, ensuring that inventory and COGS are stated at their actual cost.