What is Applied Overhead?
Applied overheads are the indirect cost that is directly linked to the production of goods but cannot be charged specifically to any of the cost objects. Such overhead cost is charged or applied by the company to its various departments or cost objects at a specific rate. while calculating the cost of goods sold for the period.
In the company, there are certain costs such as rent cost, insurance premium cost, salary to administrative staff, etc. which is part of its production costProduction CostProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. as they are incurred during production. Still, on the other hand, these costs cannot be traced back directly to any of the specific product or the service. To allocate the costs properly, management has to apply these costs to the cost objectsThe Cost ObjectsA cost object is a method that measures product, segment, and customer cost separately to determine the exact cost and selling price. properly and systematically based on certain standard methodology where these methodologies should be consistently followed from one period to another except in certain exceptional situations.
The formula is as follows –
Applied Overhead Formula = Estimated Amount of Overhead Costs / Estimated Activity of the Base Unit
- The estimated amount of overhead costsOverhead CostsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc. are the costs that cannot be allocated specifically to any of the product, department, or object are to be applied to different jobs
- The base unit’s estimated activity is the basis on which the company’s overhead is to be applied. Generally, this is the labor hours or machine hours, but it could be another method that the business thinks best suits its working.
Let’s take the example of a company named Clothy Incorporation, which deals with manufacturing clothes. Suppose the company chooses to use the labor hours as the base of the applied cost allocationCost AllocationCost Allocation is the procedure of recognizing & assigning costs to different cost objects like a product, department, program, customer, etc., as per the cost driver serving as the base for this process. . The following are the details of the transactions by the company during the financial year 2019-20:
Suppose in one job 150 hours of labor is used, calculate the applied overheads for that job
Calculation on the particular job given:
The applied overhead rate per hour is $ 14.29, and based on 150 labor hours, it comes to $2,142.86.
- Cost Ascertainment: It costs form part of the total cost of a product and helps in the cost ascertainment of the particular product.
- Managerial Decision Making: As the total cost of the product is ascertained, including applied overhead cost, it helps in managerial decision making, i.e., pricing decisions if it can go with the production of a particular product.
- Financial Reporting Purpose: One can know better which expenses to allocate to overheads. With this better classification of overheads, financial reportingFinancial ReportingFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. purposes get improved because overhead costs directly impact the business balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. and income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements..
- Certain overhead costs cannot be directly assigned to particular cost objects, i.e., rent, insurance, administrative staff compensation. All these overheads cost forms part of applied overheads. These costs are not needed for most decision-making activities. However, they are required for better accounting purposes. Hence, this cost helps the organization in its better accounting purposes and presentation.
- It can be used in future project planning. Actual overhead costs are added when the cost is actually incurred, in which case the company will not be able to ascertain the true cost of the project until the cost is actually incurred. With the help of it, managers can estimate future costs and accordingly can plan future projects.
- Many costs include fluctuations due to seasonal variations in overhead costs. For example, some overhead costs are high in summer and winter months and are relatively low in the spring and fall. However, due to the use of a predetermined overhead ratePredetermined Overhead RatePredetermined overhead rate is the distribution of expected manufacturing cost to the presumed units of machine-hours, direct labour hours, direct material, etc., for acquiring the per-unit expense before every accounting period., seasonal variations don’t have any effect in applied overhead costs. The cost can be ascertained independently.
- Apart from pricing decisions, management can make better-informed capital budgetingCapital BudgetingCapital budgeting is the planning process for the long-term investment that determines whether the projects are fruitful for the business and will provide the required returns in the future years or not. It is essential because capital expenditure requires a considerable amount of funds. decisions, in which case, it can drive the cost of capital lower by cutting down costs and increasing the profits.
This has been a guide to what is Applied Overhead. Here we discuss formula, example, and the importance of applied overhead along with benefits. You may learn more about financing from the following articles –