Applied overhead is the amount of manufacturing overhead allocated to a particular job. The normal method for doing this is to use a predetermined overhead rate.
The process of deciding on the predetermined rate is done in three steps:
- First of all determine the basis on which overhead is to be applied, this is usually machine hours or labor hours but could be another method more suitable to the business.
- Estimate the number of hours and the manufacturing overhead for the period.
- Divide the manufacturing overhead by the number of hours to give a predetermined rate per hour to be used for the period.
The predetermined rate is calculated using the following formula.
Suppose as an example, the business chooses to use labor hours as the applied cost allocation base, and estimates 36,000 production hours and 324,000 manufacturing overhead for the year. The overhead rate is determined as follows.
Overhead rate = Manufacturing overhead / Labor hours Overhead rate = 324,000 / 36,000 = 9.00 per labor hour
So on a particular job which involved say 100 hours of labor, the applied over-head would be 100 x 9.00 = 900
The journal to post the applied overhead is as follows:
|Work in process inventory||900|
|Manufacturing overhead clearing account||900|
The amount of 900 has been debited to the work in process for the job at the predetermined rate. The manufacturing overhead clearing account is a temporary account to hold the predetermined applied overhead credit until the actual manufacturing overhead is allocated to it.
Actual Manufacturing Overhead
The actual manufacturing overhead will be made up from indirect labor, indirect materials, and other costs such as depreciation, maintenance costs, insurance. When the actual manufacturing overhead is known, this is transferred to the manufacturing overhead clearing account with the following journal:
|Manufacturing overhead clearing account||1,000|
|Indirect labor wages||400|
Under Applied Overhead
If we look at the manufacturing overhead clearing account in the above example, the actual overhead was 1,000 debit, and the applied overhead at the predetermined rate was 900 credit, this leaves a debit balance on the account of 100 which represents under applied overhead. The overhead should have been 1,000 but the amount applied was actually 900.
Providing the amount is not significant, the normal process for clearing the temporary account is to charge the under applied overhead to cost of goods sold.
|Cost of goods sold||100|
|Manufacturing overhead clearing account||100|
Over Applied Overhead
The opposite situation occurs when there is over applied overhead. Suppose in the above example the actual overhead was 700, the manufacturing overhead clearing account would have shown a debit of 700 and a credit of 1,000 representing the predetermined applied overhead. The balance on the account would be a credit of 300. The overhead should have been 700, but the job was charged with 1,000, there is over applied manufacturing overhead of 300.
Again the journal to correct this would take the over applied overhead as a credit to the cost of goods sold.
|Manufacturing overhead clearing account||300|
|Cost of goods sold||300|
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.