Definition: Applied overhead is the amount of indirect costs that can’t be specifically matched to the production of a product but must be assigned to a cost object. In other words, it’s the amount of costs incurred by the company during in a production process that can’t be directly traced back to a specific product or service, but should be included in the cost of goods manufactured for the units produced during the period.
What Does Applied Overhead Mean?
Cost accountants use this concept to help management estimate the total production costs of a product. Think about it this way. Manufacturing a part requires more than direct labor and direct materials. The machine itself has costs associated with it and the building housing the machine also has a cost. These costs can’t be readily traced back to a single product being produced because they are indirect. Some examples include rent, utilities, insurance, and administrative staff salaries. You can’t trace rent back to a specific product. Instead management must apply these costs to objects in a systematic way.
Let’s look at an example.
ABC company produces three different types of engines for cars, Engine A, Engine B, and Engine C. Overhead costs such as utilities, rent, and administrative staff compensation, cannot be directly applied to production of these products and are therefore must allocated by management.
Thus management allocates the costs based on the total number of machine hours required to produce the specific engines. The company incurred $20,000 of overhead costs running their machines a total of 5,000 hours during the prior period. Therefore, management applies these costs at a rate of $4 per machine hour ($20,000 / 5,000 hours = $4 per machine hour). Of the 5,000 machine hours, Engine A used 1,000 hours, Engine B used 2,000 hours, and Engine C used 2,000 of machining time.
Thus, management would allocate $4,000 of costs to Engine A, $8,000 to Engine B, and $8,000 to Engine C. Keep in mind that this is just an estimate. We are using last year’s numbers to estimate the overhead for the current year in order to understand our cost structure and set our pricing policies accordingly.
At the end of the year, the company will perform an analysis to ensure the overhead applied equals the actual overhead costs incurred during the period. It’s not uncommon for overhead to be over applied or under applied for a period. In this case, management would have to make an adjustment to true up the applied costs to the actual costs and make a note for future rates.