Accounting For Actual And Applied Overhead: Explained

The term “overheads” refers to any expenses occurring within a business. However, it does not cover every expenditure.

Instead, it only applies to expenses not related to a product or service directly. These may still be a part of the production process or relate to those items. However, companies cannot allocate them to a single product or service unit.

Overheads are crucial in supporting companies in their activities. These occur as a normal part of operations.

However, companies cannot trace them to a single unit of product or service produced. Other expenses may have the features that allow companies to attribute them to that unit. However, overheads are general and occur as a part of the process.

Companies further segregate their overheads under the terms actual and applied. The accounting for these overheads is more complex than recording expenses. Before discussing the accounting treatment, it is crucial to differentiate between them.

What is the difference between Actual and Applied Overheads?

Overheads include any expenses that companies cannot attribute to a single product or service. Usually, companies record expenses as they incur them.

However, the same does not apply to overheads. Companies must apply these amounts to their products and services to establish their costs. However, that is challenging without knowing the actual overheads as they occur later.

Therefore, companies estimate their overheads based on a specific activity level. Once they do so, they use the standard overhead rate to calculate the applied overheads.

These overheads become a part of the cost of a product or service. Companies use these estimates to establish the standard overhead rate for each unit produced during a period.

However, applied overheads require estimations at the beginning of an accounting period. Over that period, companies will incur expenses that become a part of their overheads. However, these are not applied overheads.

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Instead, they describe the actual amounts that companies have incurred in those areas. Therefore, actual overheads represent the number of indirect costs that companies have actually incurred.

The primary difference between applied and actual overheads is the timing. Companies use the former to estimate the costs for specific products and units. However, it does not represent the actual overheads companies have incurred. Companies account for both types of overheads during different stages in the accounting process. However, the treatment for both items relates to each other.

What is the accounting treatment for Actual and Applied Overhead?

Companies absorb applied overheads based on an estimated activity level. However, actual overheads occur after that. The primary accounting for each of these items is straightforward. However, some implications may exist in treating the differences between them. In most cases, companies will see some variations between these figures.

Primarily, companies record the applied overheads as they incur production expenses. These overheads get absorbed by each production unit. On the other hand, companies record actual overheads as they occur. These overheads do not relate to the activity level within a company. Instead, it depends on the timing of the invoice received or the expense incurred. Since these figures may differ, it creates an over- or under-absorption of overheads.

The accounting for applied overheads may differ from one company to another. Usually, companies credit the factory overhead account for the amount that the company expects to absorb. On the other side, they will debit the cost of sales account. This amount remains in the factory overhead account until the end of the accounting period. On the other side, this account will also accumulate actual overheads.

As companies incur actual overheads, they will debit the factory overhead account. On the other hand, they will credit the related payable or compensation account. Usually, these include accrued expenses, cash, and bank accounts. Over time, the actual overheads keep accumulating on the debit side of the factory overhead account. However, that does not conclude the accounting for actual and applied overheads.

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At the end of each accounting period, companies calculate the balance on the factory overhead account. This balance can be credit or debit.

Based on that, companies can determine if they have over-or under-absorbed overheads. In other words, they can establish if the applied overheads were higher or lower than anticipated compared to the actual. This way, they can create an associated double-entry.

How to record the journal entries for Actual and Applied Overheads?

The first stage of accounting for overheads is when calculating applied overheads. At this stage, companies estimate that amount and allocate it to every job or project individually.

If companies have a continuous production cycle, they can apply it to the inventory produced. However, it does not entail creating a different set of journal entries for applied overheads.

Instead, companies account for applied overheads when recording inventory. On top of that, it only occurs if companies use a periodic inventory system.

If they utilize a perpetual system, the accounting becomes more complicated. In either case, applied overheads become a part of inventory valuation. Therefore, companies also account for them accordingly.

However, the accounting for actual overheads differs. As stated above, companies record these overheads when they occur. Usually, these may include expenses relating to various areas within a business.

Companies account for actual overheads in several stages. Nonetheless, the combined journal entries may look as follows.

DateParticularsDrCr
 Factory overheadsXXXX 
 Direct material payableXXXX
 Salaries payableXXXX
 Other factory overheads XXXX

When the accounting period ends, the actual and applied overheads may vary. Consequently, companies must determine the journal entries for that stage.

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If the applied overheads are higher than the actual numbers, companies must treat them as over-applied. In that case, the journal entries will be as below.

DateParticularsDrCr
 Factory overheadsXXXX 
 Cost of goods sold XXXX

However, if the actual overheads exceed the applied overheads, companies must treat them as over-applied. In that case, the journal entries for the adjustment will be the opposite of under-applied. It may look as follows.

DateParticularsDrCr
 Cost of goods soldXXXX 
 Factory overheads XXXX

Example

A company, ABC Co., estimates its overheads for an accounting period to be $100,000. The company estimates these overheads based on a level activity of 1,000 units.

ABC Co. allocates the amount to its production units over the period. However, the company incurs actual overheads of $120,000 during that period. ABC Co. uses the following journal entries to record those overheads.

DateParticularsDrCr
 Factory overheads$120,000 
 Accrued expenses $120,000

However, these journal entries only account for the actual overheads. They do not consider whether ABC Co. has over- or under-applied their estimated overheads. Based on the above, applied overheads are lower than the actual expenses. Therefore, ABC Co. has under-applied those overheads.

Based on this situation, ABC Co. must treat the difference as under-applied. The company uses the following journal entries to record it.

DateParticularsDrCr
 Cost of goods sold$20,000 
 Factory overheads $20,000

The above journal entries will conclude the accounting for actual and applied overheads for ABC Co.

Conclusion

Actual and applied overheads are a part of the accounting process for production companies. The latter occurs when companies estimate their expenses and allocate them to goods based on an activity level.

However, this amount may not be the same as the actual overheads incurred during an accounting period. Therefore, companies must consider the difference between them and how to account for these items.