Applied overhead is a crucial concept in cost accounting, representing the allocation of indirect costs to products or services. It plays a significant role in determining the true cost of production and pricing decisions. In this article, we will explore the concept of applied overhead, its importance, and how it is calculated and allocated in various industries.
The first step in understanding applied overhead is to differentiate it from actual overhead. Actual overhead refers to the total indirect costs incurred by a company, such as rent, utilities, and salaries of administrative staff. Applied overhead, on the other hand, is the portion of these costs allocated to specific products or services based on a predetermined rate.
Calculating applied overhead involves determining the overhead rate, which is typically based on a cost driver. A cost driver is a factor that causes overhead costs to be incurred, such as machine hours, labor hours, or direct labor costs. By multiplying the cost driver by the overhead rate, we can allocate the appropriate amount of overhead to each product or service.
One common method for calculating the overhead rate is the predetermined overhead rate. This rate is established at the beginning of the accounting period and remains constant throughout the period. To calculate the predetermined overhead rate, divide the estimated total overhead costs by the estimated total cost of the cost driver. For example, if a company expects to incur $100,000 in overhead costs and expects to use 10,000 machine hours, the predetermined overhead rate would be $10 per machine hour.
Once the predetermined overhead rate is determined, it is applied to the actual usage of the cost driver for each product or service. This results in the applied overhead for each unit produced. For instance, if a product requires 5 machine hours, the applied overhead for that product would be $50 ($10 per machine hour multiplied by 5 machine hours).
The accurate allocation of applied overhead is essential for several reasons. Firstly, it ensures that the cost of each product or service reflects the true cost of production, including both direct and indirect costs. This information is vital for pricing decisions, as it helps companies set prices that cover all costs and generate a profit.
Secondly, applied overhead is used in performance evaluation and cost control. By comparing the applied overhead to the actual overhead, companies can identify inefficiencies and take corrective actions. This helps in improving the overall profitability and efficiency of the business.
However, there are challenges in applying overhead accurately. One of the main challenges is selecting the appropriate cost driver. The choice of cost driver can significantly impact the allocation of overhead, and an incorrect choice can lead to misleading cost information. Therefore, it is crucial to carefully analyze the business operations and select a cost driver that best represents the consumption of overhead resources.
In conclusion, applied overhead is a critical concept in cost accounting, providing a means to allocate indirect costs to products or services. By calculating and applying overhead accurately, companies can make informed pricing decisions, improve performance evaluation, and control costs. While challenges exist in selecting the appropriate cost driver, understanding the importance of applied overhead and its correct allocation can lead to better financial management and business success.
