What do you mean by Applied overhead?

By definition, overhead cannot be traced directly to jobs.  Most company use a predetermined overhead rate (or estimated rate) instead of actual overhead for the following reasons:

•A company usually does not incur overhead costs uniformly throughout the year. For example, heating costs are greater during winter months. However, allocating more overhead costs to a job produced in the winter compared to one produced in the summer may serve no useful purpose.

•Some overhead costs, like factory building depreciation, are fixed costs. If the volume of goods produced varies from month to month, the actual rate varies from month to month, even though the total cost is constant from month to month. The predetermined rate, on the other hand, is constant from month to month.

•Predetermined rates make it possible for companies to estimate job costs sooner. Using a predetermined rate, companies can assign overhead costs to production when they assign direct materials and direct labor costs. Without a predetermined rate, companies do not know the costs of production until the end of the month or even later when bills arrive. For example, the electric bill for July will probably not arrive until August. If Creative Printers had used actual overhead, the company would not have determined the costs of its July work until August. It is better to have a good estimate of costs when doing the work instead of waiting a long time for only a slightly more accurate number.

Predetermined overhead rates

Predetermined overhead rates are used to apply overhead to jobs until we have all the actual costs available.  To create the rate,  we use cost drivers to assign overhead to jobs. A cost driver is a measure of activities, such as machine-hours, that is the cause of costs. To assign overhead to jobs, the cost driver should be the cause of the overhead costs, or at least be reasonably associated with the overhead costs. Just as automobile mileage is a good cost driver for measuring the cause of gasoline consumption, machine-hours is a measure of what causes energy costs. By assigning energy costs to jobs based on the number of machine-minutes or hours the job uses, we have a pretty good idea of the energy costs required to produce the job.

Most manufacturing and service organizations use predetermined rates.

To calculate a predetermined overhead rate, a company divides the estimated total overhead costs for a period by an estimated base (or expected level of activity). This activity could be total expected machine-hours, total expected direct labor-hours, or total expected direct labor cost for the period. Companies set predetermined overhead rates at the beginning of the year in which they will use them.  This formula computes a predetermined rate:

Notice how the predetermined rate is based on ESTIMATED overhead and the ESTIMATED base or level of activity.  To apply overhead, we will use the actual amount of the base or level of activity x the predetermined overhead rate.  Again, to apply overhead use this formula:

To demonstrate, assume the accountants at Creative Printers estimated overhead related to machine usage to be $ 120,000 for the year and estimated the machine usage for the year to be 60,000 machine-hours. Thus, the predetermined overhead rate would be calculated as follows:

If we want to apply overhead to jobs.  Job 106 had 875 machine hours and Job 107 had 4,050 machine hours.  The calculation for actual overhead for each job would be:

Actual Overhead

Actual Overhead costs are the true costs incurred and typically include things like indirect materials, indirect labor, factory supplies used, factory insurance, factory depreciation, factory maintenance and repairs, factory taxes, etc.  Actual overhead costs are any indirect costs related to completing the job or making a product.  Next, we look at how we correct our records when the actual and our applied (or estimated) overhead do not match (which they almost never match!).

As the overhead costs are actually incurred, the Factory Overhead account is debited, and logically offsetting accounts are credited. The table below provides representative examples.

The indirect labor would relate to the cost of factory staff not directly involved in production. This can include break time of line workers, shop managers, maintenance, guards, and so forth. The indirect materials relates to supplies and components that are not a significant cost item. Importantly, selling and administrative costs not related to production (e.g., advertising, salaries for non-production related staff, sales commissions, rent of the corporate offices, etc.) are separately expensed, and are not part of factory overhead. A typical entry to record factory overhead costs would be as follows:

To recap, the Factory Overhead account is not a typical account. It does not represent an asset, liability, expense, or any other element of financial statements. Instead, it is a “suspense” or “clearing” account. Amounts go into the account and are then transferred out to other accounts. In this case, actual overhead goes in, and applied overhead goes out.

The Balance Of Factory Overhead

Since the Factory Overhead account is debited for actual overhead incurred and credited for allocated (applied) overhead, the general ledger account would appear as follows (the job costs are newly assumed for this illustration):

The next graphic provides a visual representation of the cost flow associated with the Factory Overhead account. In this case, the applied overhead equaled the actual overhead, leaving a zero balance. This means that the predetermined allocation rate was exactly what was incurred during the period. More often than not, this level of perfection will not result.

Underapplied Overhead

  MyExceLab

A more likely outcome is that the applied overhead will not equal the actual overhead. The following graphic shows a case where $100,000 of overhead was actually incurred, but only $90,000 was applied.

This last situation is called underapplied overhead. It is said to be an “unfavorable” outcome, because not enough jobs were produced to absorb all of the overhead incurred. This might result from below normal levels of output or overspending. In any event, the fact remains that more was spent than allocated. Because the Factory Overhead account is just a clearing account (not a financial statement account), the remaining balance must be transferred out. Several options are available for disposing of this amount, but one approach is to remove (credit) the underapplied amount and charge (debit) Cost of Goods Sold:

The preceding entry has the effect of reducing income for the excessive overhead expenditures. Only $90,000 was assigned directly to inventory and the remainder was charged to cost of goods sold.

Overapplied Overhead

If the applied overhead exceeds the actual amount incurred, overhead is said to be overapplied. This is usually viewed as a favorable outcome, because less has been spent than anticipated for the level of achieved production.

The next journal entry shows the reduction of cost of goods sold to offset the amount of overapplied overhead:

Always keep in mind that the goal is to “zero out” the Factory Overhead account and measure the actual cost incurred. In this last example, $100,000 was actually spent and accounted for: $110,000 charged to specific jobs and $10,000 offset as a reduction in cost of goods sold.

These illustrations of the disposition of under- and overapplied overhead are typical, but not the only solution. A more theoretically correct approach would be to reduce cost of goods sold, work in process inventory, and finished goods inventory on a pro-rata basis. However, this approach is cumbersome and occasionally runs afoul of specific accounting rules discussed next.

Influence Of GAAP

Although managerial accounting information is generally viewed as for internal use only, be mindful that many manufacturing companies do prepare external financial statements. And, generally accepted accounting principles dictate the form and content of those reports.

For example, generally accepted accounting principles require that underapplied overhead relating to idle facilities, wasted material, the allocation of fixed production overhead, and so forth, be charged to current period income by means similar to those just illustrated.

Did you learn?Discuss the issues and problems associated with accounting for factory overhead.How is actual overhead cost accumulated?Describe the basic content of the Factory Overhead account.What is meant by over- and underapplied overhead, and how do such amounts emerge from within the accounting system?

What is actual and applied overhead?

What is applied overhead formula?

What type of account is overhead applied?