Overhead

Overhead Definition: Overhead, defined in as those ongoing expenses of running a business that do not directly relate to its core operations, is ever present in the mind of accountants. The overhead definition includes the costs that are necessary for the business to continue operations, but that do not actually generate profits for the business.

Overhead Explanation:
Overhead examples include rent payments, utility bills, advertising expenses, insurance costs, interest payments, legal fees, taxes, and other expenses. Overhead may also be called overhead costs, overhead expenses, manufacturing overhead costs, factory overhead, or burden.

Overhead Variance:
Overhead variance refers to the difference between actual overhead and applied overhead. Overhead variance can only be computed after the actual overhead costs for the period are known. Overhead is applied based on a predetermined rate and a cost driver. This is essentially a way of estimating overhead costs before they are actually incurred. At the end of the fiscal period, it is possible to compare the actual overhead costs with the predetermined estimates. The difference between the actual overhead costs and the applied overhead costs are called the overhead variance.


Underapplied Overhead:
When the actual amount of overhead expenses exceeds the applied amount of overhead expenses, the difference is called underapplied overhead. The predetermined rate underestimated the overhead costs for the period, and the applied overhead expenses were lower than the actual overhead expenses. The predetermined rate did not apply enough overhead expense for the period, so the difference is called underapplied overhead.

Overapplied Overhead:
When the applied amount of overhead expenses exceeds the actual amount of overhead expenses, the difference is called overapplied overhead. The predetermined rate overestimated the overhead costs for the period, and the applied overhead expenses were higher than the actual overhead expenses. The predetermined rate applied too much overhead expense for the period, so the difference between the two amounts is called overapplied overhead.

Overhead Formula:
There is not set overhead formula due to the vast differences in overhead amounts based on business models. The overhead calculation is subject to many different approaches based on industry, the differences of overhead expenses, and more. This makes accounting for overhead costs more complicated than it may appear initially.

Overhead Accounting:
Overhead Expense Allocation:
One of the issues regarding overhead expenses is how to report them in the financial statements. They are not directly related to the core operations, however, ignoring overhead costs when determining the costs of production would not accurately reflect the full cost of production. Therefore at least some portion of overhead costs is typically assigned to production activities and units of output.

Fixed overhead refers to the overhead that is not related to or applied to production. These costs do not fluctuate with production activity and are reported as period costs. Variable overhead refers to the overhead that is applied to production. These costs fluctuate with production activity and are reported as product costs. Overhead that is applied to production activities and units of output is applied using a cost driver and an overhead rate.

The cost driver is an activity that can be used to quantify and apply variable costs. For example, a certain amount of variable overhead expenses may be applied to production based on the number of direct labor hours involved in production, or based on the quantity of direct material used in production. The overhead rate is the rate at which variable overhead is applied to production and units of output based on the cost driver activity.

Reporting Overhead Variance:
At the end of the fiscal period, the company must account for the amount of overhead variance. There are two ways to do this. First, the overhead variance can be transferred to the Cost of Goods sold account. This is typically done when the overhead variance is comparatively insignificant. The second alternative is to prorate the overhead variance to an inventory account, such as Work in Progress, Finished Goods, or Cost of Goods Sold. In this case, the overhead variance is applied evenly across the units of inventory in the relevant account. Overhead variance is typically prorated when the amount is comparatively substantial.