What is Overhead Application?

Overhead application is the assignment of factory overhead costs to the units produced in a reporting period. The assignment is based on either a standard overhead rate that is used for multiple time periods, or a calculation that is specific to each reporting period. Overhead application is conducted in order to capitalize certain overhead costs into inventory. If the number of units on hand increases by the end of a reporting period, this means that a portion of factory overhead will be carried forward into the next period as an asset.

The Overhead Application Process

The steps required to apply overhead are as follows:

Identify overhead costs. Examples are rent, utilities, depreciation, and maintenance costs.
Choose an allocation base. Decide on the basis for distributing overhead. Common allocation bases include direct labor hours, machine hours, direct material costs, and units produced. The base should have a strong cause-and-effect relationship with the overhead costs.
Calculate the overhead rate. Use either historical data or budgeted amounts to derive the overhead rate. The calculation is the total overhead costs divided by the allocation base.
Apply overhead to cost objects. Apply overhead by multiplying the number of units consumed of the allocation base by the allocation rate. For example, if the overhead rate is $5 per machine hour and a product requires 10 machine hours, then the total amount of allocated overhead is $50.
Reconcile actual overhead to applied overhead. At the end of the accounting period, compare the actual overhead incurred to the overhead applied. Record adjustments in financial statements to correct for any variance between the two numbers.
Analyze and refine. Periodically review the allocation process and refine it for better accuracy or fairness. Modify allocation bases or rates if the cost drivers have changed.

These steps ensure that overhead costs are allocated systematically and equitably, providing a clear picture of the true cost of production or services.

Example of Overhead Application

Tertiary Corporation produces orange widgets. In its most recent reporting period, it incurred $100,000 of factory overhead costs and produced 20,000 orange widgets. Based on this information, Tertiary’s accountant applies overhead to the widgets at the rate of $5 per widget (calculated as $100,000 factory overhead ÷ 20,000 widgets). Tertiary then sells 15,000 widgets, which means that $75,000 of the factory overhead has now been recognized as an expense through the cost of goods sold account, while the remaining $25,000 of overhead resides in the firm’s finished goods inventory.