When business managers create a budget, they must allow for a multitude of operating costs other than the direct expenses of purchasing or manufacturing the products the firm sells. These other costs are considered overhead or indirect costs because they're not directly related to product acquisition. Although applied overhead doesn't impact many business decision-making activities, it's extremely useful as part of the firm's price-setting strategy.
Accounting standards require that a portion of overhead cost be allocated or applied to an identifiable "cost object" such as a unit of production. Managers generally use a standardized algorithm to allocate and assign overhead.
The costs of operating a business break down into direct and indirect costs. Direct costs are expenses for acquiring products to sell. In manufacturing, this typically means raw materials and direct labor, while in retail it's the cost of purchasing goods for resale. Indirect costs are necessary expenditures that aren't directly related to the production or purchase of goods. These indirect costs are the components of overhead. Because overhead isn't linked directly to production, a portion of the total overhead cost must be allocated and applied to each unit of production.
For instance, property taxes are one overhead item. However, there's no specific amount of property tax required to make one unit. The same is true of other overhead items like rent, utilities, office expenses and salaries, maintenance and security. Businesses typically use a standardized methodology for allocating and applying overhead costs to individual units of production. In manufacturing, the basis for applying overhead costs is usually direct labor hours or machine hours.
A company may apply overhead costs in other contexts. For example, a large corporation might apply a portion of its headquarters costs to each of several subsidiaries or geographical areas. This is done to satisfy accounting requirements. However, it's chiefly in manufacturing that allocation is a priority because accurate application of overhead costs is critical to determining the true cost of a product, which is in turn essential for price setting.
Before you calculate applied overhead costs, you must determine how much overhead should be allocated per unit. Many businesses allocate overhead based on direct labor hours required to make a product. In cases where a factory is highly automated, machine hours may be used instead.
First, determine the direct labor hours required to manufacture one unit by dividing the total labor hours by the number of units to be produced. Suppose you have a full-time workforce of 40 employees each working 2,000 hours per year. This equals 80,000 hours. Company records show that this workforce can make 40,000 units. Dividing the hours by the expected units of production yields labor hours per unit.
Next, determine total overhead costs. You can estimate these by reviewing company records and current costs such as utility bills and rental agreements. Aggregate all overhead items into a total cost figure. Suppose your factory overhead costs total $1.6 million. Divide the total overhead by the total labor hours to allocate overhead per hour. If the total overhead is $1.6 million and total labor hours are 80,000, this works out to $20 of overhead per labor hour.
Calculate applied overhead costs by multiplying the hours required to manufacture one unit by the allocated overhead amount. In this example, you have 2 hours per unit times $20, so apply $40 overhead costs per unit.
When managers apply overhead costs as part of the budgeting process, they're necessarily making an estimate. This is because they can't tell with absolute certainty how many units will be manufactured. To determine applied overhead for the year, they must multiply the actual number of units produced by the allocated overhead.
Suppose a factory produces 41,000 units for the year with the allocated overhead of $40 per unit. Multiply 41,000 by $40 to calculate overhead costs for the year of $1,640,000. This figure is still an estimate because some overhead costs can't be precisely known in advance. The exact determination occurs when figures are totaled at year's end.