Fixed Manufacturing Overhead Applied

Fixed manufacturing overhead applied is the portion of a factory's fixed overhead costs that has been assigned to products during a period. It is calculated by multiplying a predetermined fixed overhead rate by the units of the allocation base, such as machine hours or direct labor hours, associated with the output. In a standard costing system the base is the standard hours allowed for the actual output; in a normal costing system it is the actual hours used.

Fixed manufacturing overhead includes costs such as factory rent, depreciation on plant and equipment, property taxes, insurance and supervisors' salaries, which do not change with production volume in the short run. Applying these costs to units is required under absorption costing, the method used for external financial reporting under US GAAP. Under variable costing, fixed overhead is not applied to products at all but charged to expense in full each period.

A bakery pays the same rent each month whether it bakes 5,000 loaves or 8,000. To know what a loaf really costs, it needs to give each loaf a share of the rent. But it cannot wait until the end of the year to find out how many loaves it made, so it sets a rate in advance, say 20 cents a loaf, based on the number it expects to bake.

Each loaf baked then picks up 20 cents of rent. The total rent charged to loaves in this way is the applied amount. If the bakery bakes more than expected, it will have charged more rent to loaves than it actually paid; if it bakes fewer, it will have charged less. Those gaps are sorted out at the end of the period.

The predetermined fixed overhead rate is set at the start of the year:

The denominator is the expected or normal level of activity, often based on budgeted capacity. Fixed overhead applied is then:

Suppose a plant budgets fixed overhead of $360,000 and a denominator of 12,000 machine hours, giving a rate of $30 per machine hour. The standard is 2 machine hours per unit. During the year the plant produces 5,500 units, so the standard hours allowed are 11,000 and fixed overhead applied is 11,000 times $30, or $330,000.

As production takes place, applied overhead is charged to inventory. The entry debits Work-in-Process Inventory and credits Fixed Manufacturing Overhead (or a separate Fixed Overhead Applied account) for $330,000. The cost then flows with the units into finished goods and, when they are sold, into cost of goods sold. Actual fixed overhead costs, such as rent and depreciation, are debited to the overhead account as they are incurred.

Because the rate is based on estimates, the amount applied rarely equals the actual overhead incurred. In the example, if actual fixed overhead was $368,000, fixed overhead is under-applied by $38,000. In standard costing this is split into two parts:

• A spending or budget variance of $8,000 unfavorable, the excess of actual cost over the $360,000 budget.
• A fixed manufacturing overhead volume variance of $30,000 unfavorable, the budgeted $360,000 less the $330,000 applied, which arises because output used 1,000 fewer standard hours than the denominator.

At year-end, under-applied or over-applied overhead is usually closed to cost of goods sold if small, or prorated among work in process, finished goods and cost of goods sold if material.

Applying fixed overhead gives each unit a full product cost, which is required for inventory valuation and is useful for long-term pricing. However, because fixed costs do not change with volume, the applied amount per unit is an average that depends on the denominator chosen. It should not be treated as a cost that disappears if one fewer unit is made. For short-term decisions such as accepting a special order, managers usually exclude fixed costs that will not change. Absorption costing can also raise reported profit when production exceeds sales, because some fixed overhead stays in ending inventory instead of being expensed; this is a reason companies watch inventory build-ups closely.

• Institute of Management Accountants