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 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 objects 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 –
- The estimated amount of overhead costs 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 allocation. The following are the details of the transactions by the company during the financial year 2019-20:
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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 reporting purposes get improved because overhead costs directly impact the business balance sheet and income statement.
- 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 rate, 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 budgeting 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 –