Accurate calculation of overhead applied is essential for any business, as it impacts both product pricing and financial results. Overhead refers to the set of indirect costs associated with producing a product or offering a service. In this article, we will explore the concept of overhead, its categorization, and step by step guide to calculating overhead applied.

Understanding Overhead Costs

Overhead costs are expenses that cannot be easily traced back to a single product or service. These costs are necessary for running a business but do not have a direct connection with the manufacturing process or service delivery. Examples of overhead costs include rent, utilities, insurance, and office supplies.

Categorization of Overhead

Overhead comprises three primary categories:

1. Manufacturing Overhead: This includes all indirect production costs, such as factory maintenance, depreciation on manufacturing equipment, factory utilities, and indirect labor like supervisors or janitors.

2. Administrative Overhead: These costs refer to expenses incurred in managing the business and include office salaries, rent for office space, office supplies, and depreciation on computers.

3. Selling Overhead: These are expenses associated with marketing and sales efforts like advertising, sales commissions, and marketing materials.

Calculating Overhead Applied

Now that we know the categories of overhead, let’s explore how to calculate overhead applied using the following steps:

1. Determine allocation base: The first step is to choose an appropriate basis for allocating overhead costs. Common bases include direct labor hours, direct labor cost, or machine hours.

2. Calculate total overhead costs: The next step is to calculate the total overhead (manufacturing, administrative and selling) for a given period – either monthly or annually depending on your requirements.

3. Determine direct labor cost/hours or machine hours: Identify the specific amount of your chosen allocation base for that period.

4. Calculate overhead application rate: Divide total overhead costs by the total amount of the chosen allocation base.

This will give you the overhead application rate, expressed as a percentage or rate per hour.

Overhead Application Rate = Total Overhead Costs / Total Allocation Base

5. Apply overhead to products or services: Multiply the overhead application rate by the specific amount of chosen allocation base incurred during the production of each product or delivery of services.

Overhead Applied = Overhead Application Rate x Allocation Base (For each product/service)

Conclusion

Calculating overhead applied is an essential process for businesses to ensure accurate product cost determination and better financial results. By understanding the different categories of overhead costs and following the steps detailed in this guide, businesses can estimate these costs effectively and use this information to optimize pricing strategies and budgeting decisions.