Definition
Applied overhead is a term used in cost accounting that refers to the amount of overhead costs assigned to a particular production job or department based on a specific activity measure. These measures can include direct labor hours, machine usage time or material costs. The application of overhead costs helps give a more accurate picture of total production costs.
Key Takeaways
- Applied Overhead refers to the amount of overhead cost allocated to a specific cost object such as a product or job based on a certain measure such as machine hours or labor hours.
- It is used in cost accounting to determine the total cost of production, which includes not only direct materials and labor but also overhead expenses incurred in the production process.
- This method ensures that all costs are recognized in the accounting period in which they are incurred, providing more accurate product costing and profitability analysis.
Importance
Applied overhead is a significant term in finance as it aids in the accurate allocation of indirect costs to produced goods and services.
Companies use it to determine the total cost of production, which subsequently affects pricing decisions, budgeting, cost management, and financial analysis.
Since overhead costs such as utilities, rent, or indirect labor cannot be directly traced to a specific product, they are estimated or ‘applied’ based on a predetermined overhead rate.
The accuracy of applied overhead is vital to prevent over or under-apportioning of costs and to facilitate precise profitability analysis and business decision-making.
Explanation
Applied overhead is a concept in financial accounting that’s used to determine the costs incurred during the production of goods or services. Instead of focusing directly on the production costs, such as material and labor expenses, applied overhead considers indirect expenses related to production, such as utilities, maintenance, or rent. These costs are called overhead because they do not tie directly into a specific product or service, but they are still integral to the overall operating environment.
The term ‘applied’ denotes that these overheads have been allocated or applied to the cost of goods sold and inventory, making them a crucial element to understanding the total cost of production in a business. The purpose of applied overhead is to provide a more accurate and holistic view of the actual costs associated with producing a product or service. It is used to evenly distribute expenses and to ensure that all costs are represented in product pricing.
By including applied overhead in product cost calculations, managers can make better-informed decisions about pricing, profitability, and performance efficiency. This helps to prevent underpricing or overpricing products, and provides a meaningful basis for measuring the financial health of a business. Without accounting for applied overhead, businesses run the risk of not covering all costs in their pricing, which could potentially lead to financial loss.
Examples of Applied Overhead
Manufacturing Industry: Applied overhead is commonly used in manufacturing industries where indirect costs are often allocated to different products. For example, a furniture manufacturer will have applied overhead costs such as factory electricity, machine depreciation, factory rental, security, or maintenance. These overhead costs are not directly linked to one piece of furniture, so they are spread across all products manufactured.
Construction Industry: In this industry, overhead costs might include the cost of site upkeep, project management salaries, site security, and equipment leases, which cannot be directly attached to a specific construction project. These costs are then applied across various projects, based on an appropriate allocation base, such as direct labor hours or machine hours.
Healthcare Industry: In a hospital, overhead costs may include salaries of staff not directly involved in patient care (such as administration or janitorial services), depreciation of equipment, utilities, and building maintenance. These costs are applied across the different departments or services of the hospital using an appropriate cost driver, like the number of patients seen or the number of bed days.
FAQs on Applied Overhead
1. What is Applied Overhead?
Applied Overhead refers to the indirect costs attributed to producing a good or service, which are then applied to various cost objects within a business, such as departments or products.
2. How is Applied Overhead calculated?
The Applied Overhead is typically calculated by multiplying the predetermined overhead rate with the actual amount of the cost allocation base incurred by the business.
3. Why is Applied Overhead important?
The application of overhead allows businesses to allocate indirect costs accurately to the cost of goods or services. This allocation provides a more clear understanding of the actual cost of producing goods or services and allows for more accurate pricing and profitability analysis.
4. What is the difference between Actual and Applied Overhead?
Actual Overhead is the real costs incurred by a business during a specific period, while Applied Overhead is the estimated costs used for budgeting purposes. Differences between these values are accounted for as either under or over-applied overhead.
5. What is Overhead Absorption?
Overhead Absorption, also known as Overhead Application, is the process of distributing overhead costs or indirect costs over the cost units produced during a particular period. It allows cost accountants to assign costs more conveniently and accurately.
Related Entrepreneurship Terms
- Cost Accounting
- Job Order Costing
- Actual Overhead
- Predetermined Overhead Rate
- Overhead Absorption
Sources for More Information
- Investopedia: A comprehensive online resource for a wide range of topics in the financial field including Applied Overhead.
- AccountingTools: This site provides practical information and resources on accounting, finance and related matters.
- AccountingCoach: Detailed explanations of accounting and finance topics, as well as quizzes, crosswords, and glossaries to help with learning.
- Corporate Finance Institute: Offers a variety of online courses and certifications in the field of corporate finance, investment banking, business analysis, and more.
