Calculate Applied Overhead: A Step-by-Step Guide
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Introduction
Understanding and effectively managing manufacturing costs is critical for any business. Calculating applied overhead is an essential part of this, allowing businesses to allocate indirect costs accurately across products. This calculation helps in pricing, budgeting, and financial reporting, making it key for business profitability and strategic planning.
Knowing how to calculate applied overhead involves understanding the overhead rate and its application to various products or services based on a predetermined activity base, such as machine hours or labor hours. This computation not only clarifies product costing but also aids in revealing efficiency and cost-saving opportunities in operations.
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How to Calculate Applied Overhead
To accurately calculate applied overhead, first, identify the cost object which involves determining what the overhead costs will be applied to, such as a specific job or project. Next, define what constitutes the overhead costs for the enterprise, which can include indirect materials, labor, or other indirect costs.
Determining the Variables
Three key variables are crucial: the allocation base, the predetermined overhead rate, and the planned number of cost units for the period. Commonly, the allocation base is selected from direct machine hours, direct labor hours, or a combination of both, representing the time workstations spend creating a product. Calculate the predetermined overhead rate by dividing actual overhead cost from previous periods or an accurate estimation of upcoming overheads by the allocation base. Planning the number of cost units involves estimating the production volume for the period.
Applying the Formula
With the variables determined, apply the formula: applied overhead = (predetermined overhead rate) × (direct labor hours for the cost unit). Accountants generally use labor hours to allocate costs across jobs. Furthermore, when using estimated figures, apply the formula applied overhead = (estimated amount of overhead costs) / (estimated activity of the base unit). This method helps distribute overhead costs equitably across different cost objects.
Practical Example
For instance, Clothy Incorporation calculates its applied overhead by determining the applied overhead rate per hour using applied overhead per hour = (total applied overhead cost) / (total labor hours used). If a job utilized 150 labor hours and the overhead rate per hour was $14.29, the applied overhead for the job would be $2,142.86.
By meticulously following these steps and accurately applying the formulas, businesses can effectively allocate overhead costs to various projects and activities, ensuring more precise cost management and pricing strategies.
How to Calculate Applied Overhead
Step 1: Identify the Cost Object
Begin by determining the cost object that will be the focus of the overhead application. This could be a specific product, project, or department within your company.
Step 2: Define the Overhead
Clarify all components of overhead costs, which may include indirect materials, labor, or other expenses not directly tied to a product.
Step 3: Determine Key Variables
Establish three essential variables for the calculation: the allocation base, the predetermined overhead rate, and the planned number of cost units. The allocation base can either be direct machine hours, direct labor hours, or a combination of both, symbolizing the time spent by workstations to create a product.
Step 4: Calculate the Predetermined Overhead Rate
The predetermined overhead rate is calculated by dividing previous or estimated future overhead costs by the allocation base. Utilize the formula predetermined overhead rate = actual overhead cost / allocation base.
Step 5: Apply the Formula
Using the predetermined overhead rate and the direct labor hours required per cost unit, calculate the applied overhead. The formula to determine the applied overhead is applied overhead = predetermined overhead rate × direct labor hours. This formula provides the overhead cost assigned to each unit of production.
Example Calculation
For example, if a company has an overhead of $100,000 and foresees 15,000 direct labor hours in the current period, then the predetermined overhead rate is $6.67 per direct labor hour. For a product that takes 250 direct labor hours to create, the applied overhead is 250 direct labor hours × $6.67 = $1,667.50.
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Examples of Calculating Applied Overhead
Example 1: Plant-Wide Overhead Rate
To calculate the plant-wide overhead rate, sum all overhead costs for the period and divide by the total base activity units. If total overheads are $120,000 and total machine hours are 20,000 hours, the rate is calculated as $120,000 ÷ 20,000 = $6 per machine hour. Apply this rate to each product based on its machine hours.
Example 2: Departmental Overhead Rate
For a company with different departments incurring various overhead expenses, calculate the overhead rate for each department separately. If the assembly department incurs $50,000 in overhead on 10,000 labor hours, its rate is $50,000 ÷ 10,000 = $5 per labor hour. Multiply this rate by the labor hours each product consumes in the assembly department.
Example 3: Activity-Based Costing (ABC)
ABC assigns overhead costs to products based on their use of activities. Suppose driving a forklift is an activity with $30,000 in overhead and 6,000 forklift hours as the activity driver. The overhead rate is $30,000 ÷ 6,000 = $5 per forklift hour. Assign this overhead to products based on their specific forklift hour consumption.
Example 4: Job-Order Overhead Application
In job-order costing, overhead is applied based on estimated rates. Assume an estimated overhead of $75,000 and estimated machine hours of 15,000. The overhead rate is $75,000 ÷ 15,000 = $5 per machine hour. This rate is then applied to each job based on its actual machine hour usage.
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Efficient Applied Overhead Calculation
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Use Cases for Calculating Applied Overhead
1. Enhanced Budgeting and Financial Planning |
By calculating applied overhead, businesses ensure accurate budgeting, preventing scenarios of underapplied overhead where the actual operational costs exceed the budgeted amounts. This precision aids in maintaining cost within expected limits and enhances overall financial control. |
2. Improved Cost Management |
Knowledge of applied overhead allows for more effective tracking of manufacturing and operational costs. Enterprises can thus adjust processes to better align with financial strategies, potentially leading to significant cost savings and optimized resource utilization. |
3. Informed Pricing Strategies |
Understanding the total cost of manufacturing, including applied overhead, helps in setting product prices that cover costs and yield desired profit margins. This capability is crucial for maintaining competitive pricing while ensuring business sustainability. |
4. Enhanced Regulatory Compliance |
Calculation of applied overhead contributes to adhering to accounting standards and regulations. Accurate overhead application supports transparent and compliant financial reporting, which is particularly important for publicly traded companies or those seeking investment. |
5. Strategic Decision Making |
Insights from applied overhead calculations influence managerial decisions, such as resource allocation and operational adjustments. These strategic decisions are based on comprehensive cost visibility, driving business efficiency and effectiveness. |
6. Effective Performance Evaluation |
Calculating and analyzing overhead application assists in evaluating departmental or project performance against financial metrics. This comparison identifies areas of improvement and helps in realigning strategies with business objectives. |
Frequently Asked Questions
What is applied overhead?
Applied overhead is a fixed amount of cash added to a unit’s production cost to account for indirect production costs. It is also known as the predetermined overhead rate, overhead absorption rate, or allocated factory overhead.
How is applied overhead calculated?
Applied overhead is calculated using the formula: applied overhead = estimated amount of overhead costs / estimated activity of the base unit. The base unit can be direct machine hours, direct labor hours, or a combination of both.
What are common base units used in calculating applied overhead?
Common base units used in calculating applied overhead include labor hours and machine hours.
What costs are included in applied overhead?
Applied overhead includes indirect costs such as rent expenses, utilities, insurance, and service costs.
How do accountants handle differences between actual and applied overhead?
Accountants measure the differences between actual and applied overhead at the end of each period. This helps in assessing the accuracy of overhead allocations and making necessary adjustments.
Conclusion
Calculating applied overhead is crucial for accurate cost accounting and financial planning. By understanding how to effectively compute Applied Overhead = Overhead Rate x Actual Activity, businesses can allocate costs more precisely and make informed pricing decisions.
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