What Is Applied Overhead?
Applied overhead is a type of direct overhead expense that is recorded under the cost-accounting method. Applied overhead is a fixed rate charged to a specific production job, good produced, or department within a company. Companies use cost accounting to identify the expenses associated with manufacturing.
It is a category of overhead that is traceable. Applied overhead stands in contrast to general overhead, which is an indirect overhead, such as utilities, salaries, or rent.
- Applied overhead is a type of overhead that is a direct cost related to a specific production job, good produced, or department within a company.
- There exist different categories of overhead, such as administrative overhead, which includes costs related to managing a business.
- General overhead, or actual overhead, instead comprises indirect costs such as salaries, advertising expenses, and rent.
Understanding Applied Overhead
Overhead refers to the ongoing business expenses not directly attributed to creating a product or service. It is important for budgeting purposes but also for determining how much a company must charge for its products or services to make a profit. In short, overhead is any expense incurred to support the business while not being directly related to a specific product or service.
Applied overhead is usually allocated out to various departments according to a specific formula. Hence, a certain amount of overhead is therefore applied to a given department, such as marketing. The percentage of overhead that is applied to a given department may or may not correlate to the actual amount of overhead that was incurred by that department.
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.
Overhead is generally allocated (or applied) to cost items based on a standard methodology that is used consistently from one period to the next. For example:
- Factory overhead is applied to products based on their use of machine processing time
- Corporate overhead is applied to subsidiaries based on the revenue, profit, or asset levels of the subsidiaries
Example of Applied Overhead
For instance, a business may apply overhead to its products based on a standard overhead application rate of $35.75 per hour of machine & equipment time used. Since the total amount of machine hours used in the accounting period was 7,200 hours, the company would apply $257,400 of overhead to the units produced in that period.
From a management perspective, the analysis of applied overhead (and underapplied overhead) is a standard part of financial planning & analysis (FP&A) methods. By carefully reviewing how costs are assigned to certain products or projects, management teams can make better-informed capital budgeting decisions. In turn, with better results, management can drive the cost of capital lower, thereby increasing business valuation.