Overhead costs are those costs incurred by a business, be it directly or indirectly related to manufacturing a particular product or service offered. They are costs relevant for the consistent running of the business.
It is a necessary cost for every business as it helps determine the price to be fixed for each good produced or service rendered to make a profit.
A business overhead can either be actual or applied depending on their method of usage. Let’s discuss them.
Actual overhead is those factory costs incurred by a business but is not directly traceable to producing a particular good. They are considered indirect manufacturing costs and thus, excludes the cost of direct labor and direct material.
These manufacturing costs are not assigned to any goods produced or service rendered; instead, they are accumulated into cost pools before they get allocated to a particular product if they eventually get assigned.
A cost pool is a cost strategy used by businesses to determine the cost amassed by a particular unit or service sector during production.
Using the cost driver, companies can identify the exact cost during production and then properly allocate the identified cost to those units involved. Cost pool activity could be variable and fixed on a temporal base, used to know the cost of each production activity in a business.
A few of the many overhead costs are:
- Regular maintenance and repair of manufacturing equipment and production facilities.
- Heating gas for manufacturing facilities
- Electricity for the powering of manufacturing equipment.
- Production supervisor’s salaries and benefits.
- Security and environmental cost
- Manufacturing supplies
- Insurance and taxes on the production facilities and equipment
- Depreciation of equipment production.
- Computer and telephone systems
- advertising expenses, and rent
Applied overhead are those factory costs that are linked to a particular unit of production. They are considered the direct cost and are recorded using a cost accounting methodology.
The cost is mainly used to determine the expenses incurred during the production process. Thus, it helps in product pricing and aids in deciding the fixed price to charge a particular product or a unit of product.
Applied overhead costs are apportioned to different units of production using a particular method or formula.
As a result, this cost apportionment to other units involved in producing a product might not be precise. That is, the cost allocated to a particular unit might not be the exact percentage cost used by that unit.
Applied overhead is those costs for which it is impossible to directly apportion to a cost object, including insurance, compensation for administrative employees, rent.
A cost object is a particular unit of product for which cost is summed. Examples of a cost object are distribution channels, product line, a project, geographic territory, a service, a department, customers, a process or machine operation.
Applied overhead has a consistent method of application used by businesses over periods. For instance, say a firm decides to fix its overhead cost at $2,000,000 based on expectation.
And it also expects that its machine production rate per hour would give 50,000 units of the product next year. If the company is to allocate its overhead cost, then each unit of item would cost $40 for each production hour utilized.
The $40 was obtained by dividing the expected overhead of $2,000,000 by the total units produced which are 50,000 units, Thus $2,000,000 / 50,000 = $40.
The expected overhead costs and the expected number of machine-hours per unit production were not known with assurance. Also, having the actual machine hours won’t happen regularly.
However, the year will consistently be a distinction between the incurred actual overhead costs and the measure of overhead apportioned to the produced products. Ideally, the distinctions should not be critical at the finish of the bookkeeping year.
Let’s take another example.
Say a company allocates overhead to its goods based on an already specified standard overhead rate of $15 per hour of machine time used.
And if the cumulative amount utilized in the accounting period per machine hour is 9,600 hours, the company would apply $144,000 worth of overhead to the total units produced in the accounting period.
This overhead was obtained by multiplying the specified overhead per item made by the total amount of machine-hours used in production, that is, $15 × 9,600 hours = $144,000.
Companies usually use the strategic methodology in their overhead application. But generally, overhead is allocated in this wise:
Factory overhead is apportioned to items produced based on the machine hour used in production.
Most companies apply Corporate overhead to subsidiaries, which is usually based on their profit, accumulated revenue, or the subsidiaries’ asset level.
Applied overhead is quite an essential part of financial planning & analysis methodology. With the analysis obtained, the company’s management body can accomplish better capital use proficiency and return on capital, invested consequently expanding business valuation.
Also, by analyzing and understanding the mode by which costs are apportioned to products produced, the management body can improve capital planning and monetary-related activities choices.
If you base your item pricing on the direct cost, you will most likely cut into your profits. Therefore, it tends to be wise for various units to work on their product or service proficiency to lessen overhead costs.
Regardless of how experienced and analytical a company’s management is, applied overhead is as yet a mere estimation.
The applied overhead will probably not concur with the actual overhead costs toward the year’s end or accounting period. Therefore, the overhead that has been applied will either be much or little.
If an excessive amount of overhead has been applied to the product or service, it’s considered to have been over-applied. Then again, if too little has been applied, it is under-applied. Since the applied overhead is assigned to the cost of goods sold at the end of the accounting period, it must be corrected to mirror the actual overhead.
If a company has over-applied overhead, the distinction between the applied and actual overhead should be deducted from the sold product cost.
Furthermore, if they underapplied, it should be added. Keep in mind and applied overhead is an estimate. There are legitimate purposes behind its usage through the accounting period. However, it should be adjusted eventually.
Actual overhead or general overhead involves roundabout costs like rents, admin salary, product promoting costs, and lease. Applied overhead is a direct cost identified with a particular department or service unit of a company.
Overhead cost, be it actual or applied, generally helps in proper pricing of a company’s goods or services, which improves its profitability and long-run expansion.
Therefore, it is essential for managerial analysis and planning and thus should be given due attention by a firm’s management.