10 Apr What is Overapplied Overhead?
Manufacturing companies allocate overhead expenses to the cost of goods on an estimated basis. However, at the end of the accounting period, they may find that they have charged a greater sum towards overheads than they have incurred. This is referred to as overapplied overhead.
What does overapplied overhead mean?
When a company makes a product, its manufacturing costs include:
- Direct material costs – this is the cost of materials used directly in the manufacturing process for a particular product.
- Direct labor costs – these are the wages paid to workers that are directly attributable to the product that is manufactured.
- Overheads – certain costs cannot be allocated between different products in a satisfactory manner. There may be some workers who are not directly involved in the manufacturing process. Maintenance staff would fall into this category. It is also not practical to allocate expenses on chemicals, disposable tools, and protective devices to a product. These costs are collectively referred to as overheads.
The allocation of overhead expenses is normally done on an estimated basis. At the end of the accounting period, it may be seen that the total of the overheads that have been charged exceed the overhead expense that has been incurred. This is a case of overapplied overhead and it can occur when a company uses a standard overhead rate.
Example of overapplied overhead
Pinnacle Tiles, a roofing tile manufacturer, allocates overheads on the basis of the number of machine hours used in production. At the beginning of the quarter, it estimates that its machines will run for a total of 7,000 hours.
It allocates its total projected overhead cost of $140,000 on this basis. Accordingly, $20 ($140,000 divided by 7,000 hours) is the overhead cost of each machine-hour.
However, at the end of the quarter, the total machine-hours that have been utilized are 7,400. Consequently, a total of $148,000 (7,400 hours X $20) has been absorbed. Pinnacle Tiles has overapplied overhead because the number of actual machine-hours in the quarter exceeded the estimate.
Overapplied overhead arises when the overhead costs allocated to products in a certain period exceeds the total of the overhead expenses that have actually been incurred.