Applied overhead definition
/What is Applied Overhead?
Applied overhead is the amount of overhead cost that has been applied to a cost object. Overhead application is required to meet certain accounting requirements, but is not needed for most decision-making activities. Applied overhead costs include any cost that cannot be directly assigned to a cost object, such as rent, administrative staff compensation, and insurance. A cost object is an item for which a cost is compiled, such as a product, product line, distribution channel, subsidiary, process, geographic region, or customer.
How to Apply Overhead
Overhead is usually applied to cost objects based on a standard methodology that is employed consistently from period to period. For example, you could apply factory overhead to products based on their use of machine processing time, or apply corporate overhead to subsidiaries based on the revenue, profit, or asset levels of the subsidiaries.
The amount of overhead applied is usually based on a standard application rate that is only changed at fairly long intervals. Consequently, the amount of applied overhead may differ from the actual amount of overhead incurred by a business in any individual accounting period. The variance between the two figures is assumed to average out to zero over multiple periods; if not, the overhead application rate is altered to bring it more closely into alignment with actual overhead.
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Applied Overhead in Full Costing
Once assigned to a cost object, assigned overhead is then considered part of the full cost of that cost object. Recording the full cost of a cost object is considered appropriate under the major accounting frameworks, such as Generally Accepted Accounting Principles and International Financial Reporting Standards. Under these frameworks, applied overhead is included in the financial statements of a business.
When to Use Applied Overhead
Applied overhead is not considered appropriate in many decision-making situations. For example, the amount of corporate overhead applied to a subsidiary reduces its profits, even though the activities of the corporate headquarters staff do not assist the subsidiary in earning a higher profit. Similarly, the application of factory overhead to a product may obscure its actual cost for the purposes of establishing a short-term price for a specific customer order. Consequently, applied overhead may be stripped away from a cost object for the purposes of some types of decision making.
Example of Applied Overhead
For example, a business applies overhead to its products based on standard overhead application rate of $25 per hour of machine time used. Since the total amount of machine hours used in the accounting period was 5,000 hours, the company applied $125,000 of overhead to the units produced in that period.
As another example, a conglomerate has $10,000,000 of corporate overhead. One of its subsidiaries generates 35% of total corporate revenue, so $3,500,000 of the corporate overhead is charged to that subsidiary.
Disadvantages of Applied Overhead
There are some problems with applying overhead to cost objects. These concerns are as follows:
Obscures the direct cost. The application of overhead to a cost object can obscure its direct cost, making it more difficult to make decisions regarding that cost object. For example, a widget generates a before-overhead profit of $1.00 per unit, and a loss of -$0.50 per unit after overhead is applied. A manager would be more likely to keep selling the widget based on its profit before overhead application, and less likely to do so after the overhead application.
Time-consuming to calculate. Depending on the number of cost pools used and the complexity of the overhead application methodology, it can take a significant amount of time to apply overhead costs. This is even more of a concern in a complex production environment, where the cost application formulas may need to be reviewed and adjusted fairly frequently.
Can trigger unnecessary cost cutting. The application of overhead to a cost object can trigger management actions to reduce the amount of overhead incurred. This may result in cost reductions in areas that actually improve the long-term competitiveness of the business, such as employee training and equipment maintenance. Thus, the resulting cost cutting can reduce the efficiency of the organization over the long term.
Applied Overhead vs. Actual Overhead
Applied overhead is the amount of overhead cost that has been assigned to a cost object. The amount assigned could be based on an estimate, rather than the actual cost incurred. This differs from actual overhead, which is derived from the actual costs incurred during a reporting period. Since applied overhead may include estimated costs, it can be higher or lower than actual overhead. An ongoing task of the cost accountant is to ensure that the amount of applied overhead is kept as close as possible to actual overhead.