Applied Overhead

What is applied overhead?

Applied overhead refers to expenses allocated to a cost object, such as product lines, customers, or departments. Applied overhead costs are incurred as part of the production process but don’t tie directly back to a manufactured product or service. 

This category of overhead is recorded under the cost-accounting method. Accountants use applied overhead to estimate the total production costs of a product or service to account for other expenses such as rent, insurance, and salaries. 

Many businesses leverage accounting software to organize business finances, like applied overhead, in one place. These tools can also assist in payroll processing, invoicing, reconciliation, bill and expense management, and financial reporting.

Costs that affect applied overhead

The two costs used to determine applied overhead are:

• The estimated amount of overhead costs: Expenses that aren’t allocated to a specific product line, customer, or department. Overhead costs are considered indirect costs.

• The estimated activity of the base unit: This is typically direct labor dollars or hours, which will increase or decrease as overhead increases or decreases. If labor dollars or hours don’t feel applicable, a business can choose another method that is better suited.

How to calculate applied overhead

Calculating applied overhead only requires the overhead costs and estimated activity of the base unit. The formula to calculate it is: 

For example, Company X manufactures standing desks. Company X wants to use labor hours as the estimated activity of the base unit. The estimated overhead cost is $500,000 with 30,000 labor hours. Company X’s estimated applied overhead is $16.67 per hour of labor. 

$16.66667 = $500,000 / 30,000

Importance of calculating applied overhead

Businesses benefit from calculating applied overhead in a variety of ways. This calculation is essential because it:

• Helps inform budgets. Managing expenses is a crucial component of maintaining financial health. Calculating applied overhead enables companies to plan their budgets better and take expenses into account.

• Allows companies to make stronger pricing decisions. Businesses can determine what’s fair for their offerings while ensuring that they remain competitive in the market. 

• Makes financial reporting easier. Companies must keep track of their expenses. Having a grasp on which expenses to allocate to overhead costs makes financial reporting simpler. For example, overhead costs are crucial for balance sheets and income statement records.

Applied overhead vs. actual overhead

Applied overhead and actual overhead are different concepts in accounting. Applied overhead is the amount of overhead used to cost objects and is usually a standard rate. Actual overhead is the amount of cost incurred. These numbers do not always align.