Applied Overhead

Applied overhead is the amount of manufacturing overhead assigned to units of output, jobs or batches during an accounting period. It is calculated by multiplying a predetermined overhead rate, set before the period begins, by the actual quantity of the allocation base that each product uses, such as direct labor hours or machine hours. Applied overhead becomes part of the cost of work in process, then finished goods, then cost of goods sold.

The concept belongs to normal costing and standard costing systems, which need product costs as production happens rather than after the period ends. It contrasts with actual overhead, the indirect costs really incurred. The procedure for assigning overhead in this way is described in overhead application, and the predetermined rate itself is often called a burden rate.

A taxi meter does not wait until the end of the year to work out what the car, insurance and licence really cost per mile. It charges a set rate per mile from the start, based on an estimate made in advance. Applied overhead works the same way: each product is charged a set amount per hour or per machine run, using a rate fixed at the start of the year.

Because the rate is an estimate, the total charged over the year will not exactly equal the real bills. At year end, the business compares the two and tidies up the small difference.

The predetermined rate is set from the budget:

Applied overhead is then:

A furniture maker budgets $480,000 of overhead and 40,000 direct labor hours for the year, giving a rate of $12 per hour. A job for 20 dining tables uses 150 direct labor hours, so the job receives 150 × $12 = $1,800 of applied overhead, recorded on its job order cost sheet alongside direct materials and labor. If the plant works 41,000 hours in total during the year, total applied overhead is 41,000 × $12 = $492,000.

Applied overhead moves costs out of the overhead control account and into inventory. For the year's total, the summary entry is a debit to work in process inventory of $492,000 and a credit to Manufacturing Overhead of $492,000. Actual overhead costs, recorded throughout the year, are on the debit side of the same account.

If actual overhead was $500,000, the account has an $8,000 debit balance at year end: overhead is underapplied. If actual overhead had been $485,000, the account would show a $7,000 credit balance, meaning overhead was overapplied. An immaterial balance is closed to cost of goods sold; a material one is prorated among work in process, finished goods and cost of goods sold.

Applied overhead is only as meaningful as the base used. Labor hours suit labor-intensive work; machine hours suit automated plants where overhead consists largely of equipment costs. Some companies use a plantwide rate, while others set a departmental overhead rate for each production department so that products are charged for the departments they actually pass through. Activity-based costing goes further, using several rates linked to different activities such as setups or inspections.

In standard costing, applied overhead is often split into variable and fixed parts. The fixed part, called fixed manufacturing overhead applied, depends on the activity level chosen when setting the rate. If actual output falls short of that level, fixed overhead is underapplied even when spending is exactly on budget, which is the source of the volume variance. Choosing a realistic denominator level, such as normal capacity, keeps unit costs stable and prevents idle-capacity costs from being buried in inventory.

Applied overhead is an internal costing tool, but it reaches the financial statements through inventory and cost of goods sold. Auditors therefore review how the predetermined rate was set and whether year-end over- or underapplied balances were handled properly, so that reported product cost approximates the cost actually incurred.