Applied overhead, also known as absorbed overhead, is a pivotal concept in cost accounting that refers to the allocation of indirect costs to products, services, or departments. This practice ensures that all costs associated with production, whether direct or indirect, are accounted for and provides a more accurate picture of product or service costs.
Historical Context
The concept of overhead allocation has evolved alongside the industrial revolution and the increasing complexity of manufacturing processes. Initially, factories needed a way to distribute indirect costs like utilities, rent, and management salaries across multiple products and services, leading to the development of various methods for applying overhead.
Calculation Methods
Applied overhead can be calculated using various methods:
1. Predetermined Overhead Rate
This method involves estimating overhead costs at the beginning of an accounting period and applying them to products based on a specific driver (e.g., machine hours, labor hours).
Formula:
Example Calculation: If estimated overhead costs are $50,000 and the estimated machine hours are 10,000:
Importance and Applicability
Applying overhead accurately is crucial for:
- Cost Control: Helps in monitoring and managing indirect costs.
- Pricing: Ensures that products are priced to cover all costs and maintain profitability.
- Financial Reporting: Provides a clearer financial picture to stakeholders.
- Decision Making: Supports management in making informed production and budgeting decisions.
Examples
Manufacturing Scenario: A furniture manufacturing company estimates its yearly overhead costs at $100,000. It decides to apply overhead based on labor hours. If the estimated labor hours are 20,000, the predetermined overhead rate is $5 per labor hour. If a particular job uses 300 labor hours, the applied overhead would be:
Considerations
When applying overhead, consider the following:
- Accuracy of Estimates: Overhead estimates should be as accurate as possible to avoid significant variances.
- Choice of Activity Base: Selecting the appropriate activity base (e.g., labor hours, machine hours) that best represents the consumption of overhead resources.
- Revisions: Periodic reviews and adjustments to the predetermined overhead rate may be necessary to reflect changes in actual overhead costs and activity levels.
Related Terms
- Direct Costs: Costs that can be directly traced to a specific product, service, or department (e.g., raw materials, direct labor).
- Indirect Costs: Costs that cannot be directly traced to a specific product, service, or department (e.g., utilities, rent).
- Overhead Rate: The rate at which overhead costs are applied to products, typically based on a predetermined calculation.
Comparisons
Applied Overhead vs. Actual Overhead:
- Applied Overhead: Based on estimated rates and activity levels.
- Actual Overhead: The actual overhead costs incurred during a period.
Interesting Facts
- The concept of overhead allocation dates back to early manufacturing practices where indirect costs needed to be distributed among products for accurate cost assessment.
Famous Quotes
“Cost accounting is enemy number one of productive work.” - Eliyahu M. Goldratt
FAQs
Q: Why is applied overhead important? A: Applied overhead ensures all indirect costs are accounted for in product pricing, aiding in accurate financial reporting and cost control.
Q: What happens if the applied overhead significantly differs from actual overhead? A: Significant variances can indicate inaccuracies in cost estimation or changes in production efficiency, necessitating a review and adjustment of the overhead rates.
References
- Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost Accounting: A Managerial Emphasis. Pearson Education.
- Drury, C. (2018). Management and Cost Accounting. Cengage Learning.
Summary
Applied overhead, or absorbed overhead, is an essential element in cost accounting, facilitating the allocation of indirect costs to products or services. Accurate calculation and application of overhead are vital for effective cost control, pricing, financial reporting, and decision-making in any production-oriented business.
By understanding and effectively managing applied overhead, organizations can better control costs, price products accurately, and make more informed financial decisions.
