Overhead incurred refers to the actual amount of overhead costs a business experiences within a specific accounting period. Overhead costs are indirect costs of running a business, and they are not directly tied to a specific product or service. These costs can include rent, utilities, administrative salaries, insurance, office supplies, and depreciation, among other things.
In cost accounting, overhead incurred is often compared with overhead applied. Overhead applied refers to the overhead costs allocated to products or services during an accounting period, using a predetermined overhead rate.
At the end of an accounting period, businesses compare overhead incurred with overhead applied to see if overhead has been overapplied or underapplied. If overhead applied is greater than overhead incurred, overhead is said to be overapplied. If overhead applied is less than overhead incurred, overhead is underapplied.
These discrepancies arise because overhead applied is based on estimated overhead costs and an estimated allocation base, while overhead incurred is the actual amount of overhead costs. Adjustments may need to be made at the end of the accounting period to correct for overapplied or underapplied overhead.
For instance, if a company incurs $80,000 of overhead costs (overhead incurred) during a period, but only applies $75,000 of overhead to its products or services (overhead applied), it has $5,000 of underapplied overhead. This discrepancy must be adjusted in the company’s accounting records.
Example of Overhead Incurred
Let’s consider an example with a company that manufactures custom furniture, called Quality Furniture Co.
At the beginning of the year, Quality Furniture Co. estimates that it will incur $1,200,000 in overhead costs for the year. It also estimates that it will have 50,000 machine hours for the year. Therefore, it sets a predetermined overhead rate of $24 per machine hour ($1,200,000 / 50,000 machine hours).
Throughout the year, Quality Furniture Co. applies overhead to its products based on this predetermined rate. For instance, if a particular piece of furniture takes 10 machine hours to produce, it applies $240 in overhead costs to that piece ($24 per machine hour * 10 machine hours).
At the end of the year, Quality Furniture Co. adds up all the actual overhead costs it has paid out. Suppose it turns out that the actual overhead costs, or overhead incurred, amount to $1,180,000.
The company also adds up all the machine hours it actually used during the year, which turn out to be 48,000 machine hours. Therefore, the actual overhead applied based on the predetermined rate is $1,152,000 ($24 per machine hour * 48,000 machine hours).
In this case, the overhead incurred ($1,180,000) is greater than the overhead applied ($1,152,000), leading to $28,000 of underapplied overhead. This discrepancy needs to be adjusted in the company’s accounting records at the end of the year.
This example demonstrates how overhead incurred and overhead applied can differ due to the use of estimates in setting the predetermined overhead rate. It also shows the need to adjust for overapplied or underapplied overhead at the end of the accounting period.