Overhead Application

Overhead application is the process of assigning manufacturing overhead to products or jobs as they are produced. Because overhead costs such as factory rent, utilities, indirect labor and equipment depreciation cannot be traced directly to individual units, they are charged to production using a predetermined overhead rate multiplied by the actual quantity of an allocation base, such as direct labor hours or machine hours, used by each job.

The amount charged through this process is called applied overhead, and the rate is often called the burden rate. Overhead application is central to job order costing and process costing under normal costing, and it is how absorption costing gives every unit a full product cost for inventory and pricing.

A car repair shop pays rent, electricity and the receptionist's wages no matter which cars come in. To price each repair fairly, it adds an amount for these shared costs to every hour of mechanic time, say $40 an hour on top of the mechanic's wage.

The shop works out that $40 at the start of the year by dividing its expected shared costs by the hours it expects to bill. It then charges every job at that rate as the work is done, without waiting for the year's final bills. At year-end it checks how close the estimate came and corrects the difference.

1. Estimate total manufacturing overhead for the coming year.
2. Choose an allocation base that drives overhead and estimate its total for the year.
3. Calculate the predetermined rate by dividing estimated overhead by the estimated base.
4. As jobs are worked on, apply overhead by multiplying the rate by the actual base used, recording it on each job cost sheet.
5. At period-end, compare applied overhead with actual overhead and dispose of the difference.

The rate is set as:

A furniture maker estimates overhead of $600,000 and 40,000 direct labor hours for the year, so its rate is $15 per direct labor hour. A job that uses 120 direct labor hours is charged $1,800 of overhead. The entry debits Work-in-Process Inventory and credits Manufacturing Overhead.

During the year, actual overhead costs of $615,000 are debited to the Manufacturing Overhead account as they are incurred, and 42,000 direct labor hours are worked, so applied overhead totals 42,000 times $15, or $630,000. Overhead is over-applied by $15,000: the account has a $15,000 credit balance.

If the difference is small, it is usually closed to cost of goods sold. In the example, the company debits Manufacturing Overhead $15,000 and credits Cost of Goods Sold $15,000, reducing cost of goods sold. Under-applied overhead would increase it. If the difference is material, it is prorated among work in process, finished goods and cost of goods sold in proportion to the applied overhead in each, so that inventory is closer to actual cost.

Companies can apply overhead with a single plantwide rate, with a separate departmental overhead rate for each production department, or with many activity rates under activity-based costing. More rates usually mean more accurate product costs, especially when products use departments or activities in very different proportions, but they also mean more record-keeping. In standard costing, fixed and variable overhead are often applied separately; see fixed manufacturing overhead applied.

Actual overhead is not known until the period ends, and much of it is fixed, so dividing actual overhead by actual activity each month would make product costs swing with seasonal output and utility bills. A predetermined rate gives stable, timely costs for pricing, bidding and inventory valuation throughout the year. The trade-off is that applied overhead is an estimate. If the allocation base does not truly drive overhead, products that use little of the base but a lot of overhead resources will be under-costed, and others over-costed, which can lead to poor pricing and product decisions.

• Institute of Management Accountants