Applied overhead is the amount of overhead cost that has been applied to a cost object. Overhead application is required to meet certain accounting requirements, but is not needed for most decision-making activities.
Applied overhead costs include any cost that cannot be directly assigned to a cost object, such as rent, administrative staff compensation, and insurance. A cost object is an item for which a cost is compiled, such as a product, product line, distribution channel, subsidiary, process, geographic region, or customer.
Overhead is usually applied to cost objects based on a standard methodology that is employed consistently from period to period. For example:
Apply factory overhead to products based on their use of machine processing time
Apply corporate overhead to subsidiaries based on the revenue, profit, or asset levels of the subsidiaries
For example, a business applies overhead to its products based on standard overhead application rate of $25 per hour of machine time used. Since the total amount of machine hours used in the accounting period was 5,000 hours, the company applied $125,000 of overhead to the units produced in that period.
As another example, a conglomerate has $10,000,000 of corporate overhead. One of its subsidiaries generates 35% of total corporate revenue, so $3,500,000 of the corporate overhead is charged to that subsidiary.
The amount of overhead applied is usually based on a standard application rate that is only changed at fairly long intervals. Consequently, the amount of applied overhead may differ from the actual amount of overhead incurred by a business in any individual accounting period. The variance between the two figures is assumed to average out to zero over multiple periods; if not, the overhead application rate is altered to bring it more closely into alignment with actual overhead.
Once assigned to a cost object, assigned overhead is then considered part of the full cost of that cost object. Recording the full cost of a cost object is considered appropriate under the major accounting frameworks, such as Generally Accepted Accounting Principles and International Financial Reporting Standards. Under these frameworks, applied overhead is included in the financial statements of a business.
Applied overhead is not considered appropriate in many decision-making situations. For example, the amount of corporate overhead applied to a subsidiary reduces its profits, even though the activities of the corporate headquarters staff do not assist the subsidiary in earning a higher profit. Similarly, the application of factory overhead to a product may obscure its actual cost for the purposes of establishing a short-term price for a specific customer order. Consequently, applied overhead may be stripped away from a cost object for the purposes of some types of decision making.