There are many moving parts in any manufacturing company. Workers and raw materials are the most apparent and visible, but it takes much more than these to manufacture a product.
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Every facility needs power, insurance, supplies, and employees who work behind the scenes and not directly in production. These indirect costs are part of manufacturing overhead, the accounting term that refers to all of the indirect expenses that go into making a product.
Some of the manufacturing overhead will require costs for wages, taxes, insurance, and fringe benefits. These would include:
- Maintenance workers to repair equipment
- Inspectors to check parts as they are produced
- Forklift operators to move material
- Supervisors and others on the management team
- Custodians to keep the production area clean
- Recordkeepers to track the process
Other expenses do not incur those additional costs:
- Electricity, heating oil, and natural gas for the facility
- Water and sewer
- Manufacturing supplies
- Repair parts for both the machinery and facility
- Computer and telephone systems
- Depreciation on the equipment and facilities
- Environmental and safety costs
- Taxes and insurance on the facilities and equipment
None of the manufacturing overhead items listed above can be traced directly to a job. And these costs are not always encountered equally throughout the year. Heating expenses are an excellent example, being higher in winter and significantly lower in the warm months. Also, the bills for these utilities might not arrive until well after the job is completed, so companies have to wait until they do to add those overhead costs and close out the job.
Most businesses overcome these variations and the waiting by using a predetermined (or estimated) overhead rate. Applied overhead, which is the amount of manufacturing overhead that’s assigned to the goods that are produced, is typically done by using a predetermined rate.
What is Applied Manufacturing Overhead?
Applied manufacturing overhead signifies manufacturing overhead expenses that have been applied to units of a product during a specific period. The predetermined overhead rate is typically calculated using direct labor hours as a basis.
For example, a business has estimated that it will have $500,000 in overhead costs over the next twelve months. The company will use 100,000 direct labor hours as its basis. By dividing $500,000 by 100,000 hours, the predetermined overhead rate becomes $5.
Now, the company has quoted $20,000 to machine a quantity of pipe fittings and completes the job with $5000 of direct labor and $7000 of materials and equipment costs. The $20,000 machining job ends up taking 250 direct labor hours, which is multiplied by the overhead rate of $5 to come up with $1,250 of applied overhead costs. Adding applied manufacturing overhead calculates the cost of goods manufactured to be $13,500 to complete the work on this project.
Many companies choose to use a formula that is established by dividing the expected overhead costs for a period by the standard labor costs. As in the previous example, the estimated overhead costs remain at $500,000, but it also expects to have $2,000,000 of direct labor costs during that same accounting time frame.
By dividing $500,000 by $2,000,000, the company has arrived at a predetermined overhead rate of 0.25. By multiplying the cost of labor $5000 with the overhead rate of 0.25, the company can determine that the applied overhead for this job is $1,250 to machine the parts, and the total manufacturing cost is $13,500.
It’s apparent that predetermined overhead rates make it possible for businesses to estimate their job costs sooner. They can assign overhead costs at the same time they assign direct raw materials and direct labour.
Since the future overhead costs and amount of direct labor costs or hours cannot be known with certainty, there will always be a difference between the actual overhead costs incurred and the amount of overhead applied to the manufactured goods. Manufacturing companies hope the differences will not be significant at the end of the accounting period.
Applied overhead versus actual overhead
So far, everything has been calculated using a predetermined rate to apply manufacturing overhead figures to individual jobs. But what happens when the actual bills start coming in on all those indirect costs? Certainly, the actual overhead, the company’s true indirect manufacturing costs, will not match up to the estimated numbers.
In most manufacturing organizations, the applied overhead is added to the materials and direct labor to calculate the cost of goods sold on every job during a specified period. At the same time, accountants are also recording the actual bills. They keep a running total of these costs and hold them aside for later.
At the end of the accounting period, these actual overhead costs are reconciled with the applied overhead to make sure that the actual overhead costs end up in the cost of goods sold.
Has the company applied too much or too little manufacturing overhead?
No matter how experienced and well-run a manufacturing company is, applied overhead is still an educated guess. At the end of the year or period, the applied overhead will likely not agree with the actual manufacturing overhead costs. The overhead that has been applied to the jobs will either be too much or too little.
If too much overhead has been applied to the jobs, it’s considered to have been over-applied. Conversely, if too little has been applied, it is under-applied. Since the applied overhead is in the cost of goods sold at the end of the period, it has to be adjusted to reflect the actual overhead.
If a company has over-applied overhead, the difference between applied and actual must be subtracted from the cost of goods sold. And if they under-applied, it must be added. Remember, applied overhead is an approximation. There are valid reasons for using it throughout the year, but it must be reconciled and adjusted in the end.