Applied Overhead

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What is Applied Overhead?

Applied overheads are the indirect cost directly linked to the production of goods but cannot be charged specifically to any of the cost objects. The company charges or applies such overhead costs to its various departments or cost objects at a specific rate. At the same time, they are calculating the cost of goods sold for the period.

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Explanation

In the company, certain costs such as rent, insurance premium, salary to administrative staff, etc., are 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 specific product or 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 -

Applied Overhead Formula = Estimated Amount of Overhead Costs / Estimated Activity of the Base Unit

Applied Overhead

Where

  • The estimated overhead costs are the costs that cannot be allocated specifically to any product, department, or object 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 or machine hours, but it could be another method that the business thinks best suits its work.

Example

Let’s take the example of a company named Clothy Incorporation, which deals with manufacturing clothes. Suppose the company uses 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:

Applied Overhead Example 1

Suppose 150 hours of labor are used in one job and calculate the applied overheads for that job.

Solution:

Applied Overhead Example 1-1

Calculation on the particular job given:

Applied Overhead Example 1-2

The applied overhead rate per hour is $ 14.29 based on 150 labor hours, which comes to $2,142.86.

Importance

Importance of Applied Overhead
  • Cost Ascertainment: It forms 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.

Benefits

  • Certain overhead costs cannot be directly assigned to particular cost objects, i.e., rent, insurance, and 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 improve its accounting purposes and presentation.
  • It can be used in future project planning. Actual overhead costs are added when the cost is incurred, in which case the company will not be able to ascertain the project's true cost until the cost is incurred. With its help, managers can estimate future costs and accordingly plan future projects.
  • Many costs include fluctuations due to seasonal variations in overhead costs. For example, some overhead costs are high in the summer and winter and relatively low in the spring and fall. However, due to the use of a predetermined overhead rate, seasonal variations don’t affect applied overhead costs. The cost can be ascertained independently.
  • Apart from pricing decisions, management can make better-informed capital budgeting decisions, which can lower the cost of capital by cutting down costs and increasing profits.