If you haven’t done any accounting work, this might be a weird concept for you, but it’s ubiquitous for manufacturing companies and service companies. Applied overhead is used not only for actual billing for products and services but also for estimating costs when looking to bid on projects or service contracts. This applied overhead cost is an ongoing, month-to-month cost that eliminates the fluctuations from heating costs in the winter to cooling costs in the summer. And this estimate is much more useful than waiting to apply actual overhead costs where that exact figure is only slightly off from the forecast.
We first need to understand what is meant when the word “overhead” is used. When you run a production business, there are several costs associated with running your production business which can’t be directly tied to the production that you are doing. For example, the lights you use in the building that all of your output happens in. The electricity used to power the lights, as well as the machines and other things, is an overhead expense. This is true of the mortgage on the building, the natural gas used to heat the building, the depreciation that happens on the machines used during production, and other things. In short, overhead comprises those required to produce the things you make but cannot readily be attributed to the products like direct materials or direct labor can.
Now we get to the critical aspect of overhead, and that is applied overhead. Applied overhead is a figure calculated from the total overhead cost divided by the number of production hours of all the machinery in the production facility. These numbers are based on historical figures, as that is the best that can be calculated. This calculated figure is then “applied” to the products produced based on the number of hours required to make each product. Essentially, this applied overhead is a predetermined rate that is used evenly to all products produced during the year. This figure can and often does change year to year based on the history of overhead costs.
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A predetermined overhead rate is a figure that is calculated at the beginning of the year and is applied evenly throughout the year for production hours or service hours (based on the business). The formula for determining what your predetermined overhead rate will be is estimated overhead divided by estimated base. This sounds simple but has several steps to it. First, the amount of overhead that was attributed to production is to be estimated/calculated. For the sake of our illustration, let’s say that this figure was $100,000. We now have half of the equation needed to calculate that predetermined overhead rate applied to production jobs.
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The second part of the equation is the estimated base. The estimated base is calculated from a cost-driver, which is a measure of activities that is the cause of the cost. Often in a production setting, this is the number of machine-hours to produce a product. This number must be an annual number for the equation because we use a yearly number for the other part of the equation. They need to be the same measurement, otherwise, we won’t have an accurate predetermined overhead rate. Perhaps you will anticipate using your production machines 50,000 hours for the year, and that’s the other part of the equation that we need.
Taking these figures and plugging them into the equation, we have $100,000 of overhead costs divided by the 50,000 hours of machine use. This equals $2 per machine hour. This is now the predetermined overhead rate that you will use on each item that is produced. If you have an order for your 20 units of a product, and it takes one machine hour per product to make, that means that you have 20 machine hours for this order. As part of your cost for producing those products, you multiply the 20 machine hours by the $2 per machine hour predetermined overhead rate, and you get $40 worth of overhead applied to the cost of producing those items.
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Okay, so we’ve gone through the exercise of generating a predetermined overhead rate, and we’ve seen how that rate, when “applied,” becomes the applied overhead for projects.But why would we want to go through this effort? The main reason to calculate this predetermined overhead rate that gets used to projects is to estimate costs ahead of time. By estimating the cost of jobs, you can know if you are competitive in the market for your product, and you can bid on projects to keep your business moving forward. You would not get much business by telling prospective customers to trust you, and then a month later, you can figure out the overhead cost associated with the project. So having an applied overhead rate that you use on projects is essential for businesses.
As we’ve seen, a few steps are required to calculate that predetermined overhead rate that gets “applied” to projects. Specifically, it is applied to the products produced or the services rendered in a business setting. While this is an important figure to know when billing for the products made or the services rendered, this is also an important figure to know when providing estimates on projects that you need to bid on. It will help you see if you can be cost-competitive in your market. Anything that you end up changing as part of your overhead costs, such as upgrading systems that make them more efficient, can positively impact this applied overhead figure.
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