The overhead definition is those ongoing expenses of running a business that do not directly relate to its core operations. It 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.
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Some examples include the following:
- Rent payments
- Utility bills
- Advertising expenses
- Insurance costs
- Interest payments
- Legal fees
- Other expenses
Overhead variance refers to the difference between actual overhead and applied overhead. You can only compute overhead variance after you know the actual overhead costs for the period. Overhead is applied based on a predetermined rate and a cost driver. This is essentially a way of estimating overhead costs before they actually incur. 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.
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 call the difference underapplied overhead.
When the applied amount of overhead expenses exceeds the actual amount of overhead expenses, call the difference 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 call the difference between the two amounts overapplied overhead.
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 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, assign at least some portion of overhead costs to production activities and units of output.
Fixed overhead refers to the overhead 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. In addition, report them as product costs. Apply overhead to production activities. Also apply units of output 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 you apply variable overhead 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, transfer the overhead variance to the Cost of Goods sold account. Do this 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 apply overhead variance evenly across the units of inventory in the relevant account. Prorate overhead variance when the amount is comparatively substantial.
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