Actual overhead is the total of indirect manufacturing costs that a factory actually incurs during an accounting period. It includes items such as indirect materials, indirect labor, factory utilities, rent, insurance, property taxes, maintenance and depreciation of production equipment. These are costs of running the plant that cannot be traced conveniently to individual units.
The term is used mainly in contrast with applied overhead, the amount assigned to products during the period using a predetermined rate. Under normal and standard costing, product costs are built with applied overhead because actual overhead is not fully known until the period ends. Comparing the two at period end reveals whether overhead was underapplied or overapplied, and the difference must be closed out before the financial statements are final.
Actual overhead in plain terms
A bakery knows the cost of the flour in each loaf, but the electricity for the ovens, the cleaner's wages and the rent on the kitchen are shared across everything it bakes. Actual overhead is simply the total of those shared bills as they really came in for the month.
During the month, the bakery uses an estimate to add a share of those bills to each batch of bread so that it can price and value its stock straight away. At the end of the month, it adds up the real bills and compares them with the estimate. The gap tells it whether it charged too little or too much.
How actual overhead is recorded
Most systems use a single manufacturing overhead control account, sometimes called factory overhead. Actual costs are debited to it as they are incurred:
- Indirect materials issued: debit Manufacturing Overhead, credit Raw Materials Inventory.
- Indirect labor: debit Manufacturing Overhead, credit Wages Payable.
- Factory depreciation: debit Manufacturing Overhead, credit Accumulated Depreciation.
- Factory utilities and insurance: debit Manufacturing Overhead, credit Accounts Payable or Prepaid Insurance.
Overhead applied to production is credited to the same account, with a matching debit to work in process inventory. The account therefore collects actual costs on the debit side and applied costs on the credit side.
Underapplied and overapplied overhead
If actual overhead exceeds applied overhead, the account ends with a debit balance and overhead is underapplied: products were charged too little. If applied exceeds actual, the credit balance means overhead was overapplied. Suppose a plant applied overhead at $12 per direct labor hour and worked 41,000 hours, applying $492,000, while actual overhead was $500,000. Overhead is underapplied by $8,000.
Small differences are usually closed directly to cost of goods sold: debit Cost of Goods Sold $8,000 and credit Manufacturing Overhead $8,000. Larger differences are prorated among work in process, finished goods inventory and cost of goods sold, in proportion to the overhead applied to each, so that inventory on the balance sheet approximates actual cost.
Why actual overhead differs from the estimate
Two separate forces cause the gap. A spending difference arises when the overhead costs themselves differ from budget, for instance because utility prices rose. A volume difference arises when actual activity differs from the activity used to set the predetermined rate, so fixed costs are spread over more or fewer hours than planned. Standard costing systems split these into separate variances, such as the spending variance and the fixed manufacturing overhead volume variance, so managers can see which force caused a favorable or unfavorable result.
Tracking actual overhead closely matters for control as well as for inventory values. Comparing each overhead line with a flexible budget adjusted for actual activity shows where spending went off plan, which is far more useful than the single net difference in the control account.
Actual overhead outside the factory
Only manufacturing overhead becomes part of product cost. Selling, general and administrative costs, such as head-office rent, sales commissions and marketing, are period costs and are expensed as incurred, even though they are also indirect. Misclassifying office costs as factory overhead inflates inventory and defers expense, so auditors check the split carefully. In service businesses, the same idea of collecting actual indirect costs and comparing them with amounts charged to clients is used to set billing rates, for example in consulting and law firms.