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.
Predetermined Rate
Generally the process of deciding on the predetermined rate is done in three steps:
- Firstly 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.
- Secondly estimate the number of hours and the manufacturing overhead for the period.
- Finally 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.
To illustrate suppose as an example, the business chooses to use labor hours as the cost allocation base, and estimates 36,000 production hours and 324,000 manufacturing overhead for the year. In this case 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
Accordingly the journal to post the applied overhead is as follows:
| Account | Debit | Credit |
|---|---|---|
| Work in process inventory | 900 | |
| Manufacturing overhead clearing account | 900 | |
| Total | 900 | 900 |
In this case 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 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:
| Account | Debit | Credit |
|---|---|---|
| Manufacturing overhead clearing account | 1,000 | |
| Indirect materials | 200 | |
| Indirect labor wages | 400 | |
| Depreciation | 100 | |
| Utilities | 250 | |
| Other costs | 50 | |
| Total | 1,000 | 1,000 |
Under Applied Overhead
If we look at the manufacturing clearing account in the above example, the actual was 1,000 debit, and the applied at the predetermined rate was 900 credit. Accordingly 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.
In this case, 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.
| Account | Debit | Credit |
|---|---|---|
| Cost of goods sold | 100 | |
| Manufacturing overhead clearing account | 100 | |
| Total | 100 | 100 |
Over Applied Overhead
The opposite situation occurs when there is over applied overhead. To illustrate suppose in the above example the actual was 700, the manufacturing clearing account would have shown a debit of 700 and a credit of 1,000 representing the predetermined applied overhead. In this case 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.
In like fashion the journal to correct this would take the over applied overhead as a credit to the cost of goods sold.
| Account | Debit | Credit |
|---|---|---|
| Manufacturing overhead clearing account | 300 | |
| Cost of goods sold | 300 | |
| Total | 300 | 300 |
Conclusion
Applied overhead is a crucial component of the manufacturing process and is used to calculate the cost of production for a specific job or product. It is the portion of manufacturing overhead costs that is specifically allocated to a particular job, based on the amount of resources that job will consume. By using a predetermined rate, a business can consistently allocate overhead costs to individual jobs and make informed decisions about pricing, production processes, and resource utilization.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. 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 degree from Loughborough University.