Overhead Application
Predetermined rates and variances.
Why This Matters
Manufacturing overhead is indirect — you cannot look at a single latte and know exactly how much rent, electricity, and manager time went into it. Instead, you estimate and assign overhead to products using a predetermined rate.
This is overhead application: converting total indirect costs into a per-unit (or per-activity) amount, then charging that amount to Work in Process as production occurs. Done well, it produces stable, predictable per-unit costs. Done poorly, it over- or under-costs products and hides performance problems.
Understanding predetermined overhead rates and overhead variances helps you know when product costs are reliable estimates — and when they are signaling issues with capacity usage, cost control, or budgeting.
Predetermined Overhead Rate (POHR)
The POHR is calculated before the period begins based on budgeted amounts:
PREDETERMINED OVERHEAD RATE (POHR)
POHR = Estimated Total Manufacturing Overhead ÷ Estimated Total Activity Base
COMMON ACTIVITY BASES:
- → Direct labor hours (DLH)
- → Direct labor cost
- → Machine hours (MH)
- → Units produced
- → Activity drivers (setups, batches, orders) in ABC systems
ABC COFFEE SHOP (annual):
Estimated MOH: $36,000
Estimated DL hours: 2,000 hours
POHR = $36,000 ÷ 2,000 = $18.00 per direct labor hour
If each drink takes 0.025 hours (1.5 minutes):
Overhead per cup = $18.00 × 0.025 = $0.45
Each time a cup is produced, $0.45 of overhead is applied to WIP.
Why Use a Predetermined Rate?
Using a POHR solves several practical problems:
Timeliness
You need product costs during the year — not after the year ends. Actual overhead isn't fully known until after the period closes.
Seasonality
Actual overhead fluctuates month to month (e.g., winter heating bills). Using actual rates would make per-unit costs swing wildly.
Cost control
Comparing actual overhead to applied overhead gives managers a variance to analyze.
Without a POHR, you might have:
- → Very high per-unit cost in low-volume months
- → Very low per-unit cost in high-volume months
The POHR smooths overhead across the year so product costs are more stable and useful for pricing and analysis.
Applying Overhead During the Period
Each time production uses the activity base, overhead is applied using the POHR.
Overhead Application Flow
Estimate MOH + Base
Before period starts
Calculate POHR
MOH ÷ Activity base
Apply to WIP
POHR × actual base
Close Variance
Actual vs. Applied
ABC COFFEE — JOB EXAMPLE
Activity base: direct labor hours · POHR: $18.00 per DLH
If a job uses 5 DLH:
Overhead applied to Job #047:
DLH used: 5 hours
POHR: $18.00/DLH
Applied overhead: 5 × $18 = $90
JOURNAL ENTRY:
DR Work in Process $90
CR Manufacturing Overhead Applied $90
This entry assigns $90 of overhead to that job's WIP balance.
Actual vs. Applied Overhead
At the end of the period, actual overhead and applied overhead will almost never be equal.
OVERHEAD VARIANCE
Underapplied Overhead = Actual > Applied
Overapplied Overhead = Applied > Actual
CAUSES:
- → Estimated MOH too low or too high
- → Estimated activity base too low or too high
- → Changes in efficiency or utilization
- → Unplanned events (equipment breakdown, rent increase)
ABC COFFEE — YEAR-END EXAMPLE:
Actual MOH: $37,500
Applied MOH (via POHR): $36,000
Underapplied overhead: $1,500
Interpretation: Jobs and inventory understated, COGS understated. You spent $1,500 more overhead than you applied to products.
Disposing of Over- or Underapplied Overhead
The overhead variance must be closed at year-end. There are two common methods.
Method 1: Close to COGS
Simple approach — used when the variance is small and inventory levels are low.
Underapplied (actual > applied):
DR Cost of Goods Sold $1,500
CR Manufacturing Overhead $1,500
Overapplied (applied > actual):
DR Manufacturing Overhead $1,500
CR Cost of Goods Sold $1,500
Method 2: Prorate to Inventories
More accurate — used when the variance is material and inventory balances are significant.
PRORATION EXAMPLE ($1,500 underapplied):
WIP: 4,000 ÷ 36,000 = 11.1% → $167
Finished Goods: 6,000 ÷ 36,000 = 16.7% → $250
COGS: 26,000 ÷ 36,000 = 72.2% → $1,083
Keeps inventory values and COGS in proportion.
PRORATION JOURNAL ENTRY (underapplied $1,500):
DR Work in Process $167
DR Finished Goods $250
DR Cost of Goods Sold $1,083
CR Manufacturing Overhead $1,500
Overhead Volume and Spending Variances (Conceptual)
In more advanced systems, overhead variance is split into two components:
Spending Variance
Did you spend more or less overhead than budgeted for the actual activity level?
Volume Variance
Did you produce more or less than the activity level used to set the POHR?
CONCEPTUAL GUIDE
If you produce less than planned, fixed overhead per unit increases, creating an unfavorable volume variance.
If you produce more than planned, fixed overhead per unit decreases, creating a favorable volume variance — but this must be interpreted carefully (e.g., overproduction risk).
Total overhead variance = spending difference ± volume difference. These variances help explain why applied and actual differ.
Choosing an Activity Base
The choice of activity base matters. The best base:
- Has a strong cause-and-effect relationship with overhead
- Is easy to measure reliably
- Reflects how products consume overhead resources
| Overhead Type | Best Activity Base |
|---|---|
| Labor-intensive operations | Direct labor hours |
| Automated plants | Machine hours |
| Setup-driven processes | Number of setups |
| Order-processing overhead | Number of orders |
| Quality-control overhead | Inspection hours |
ABC Coffee Shop
For espresso drinks: direct labor minutes may be a good base.
For catering jobs: number of orders or setups might better reflect overhead use. Misaligned bases (e.g., using labor hours when overhead is driven by machine setups) cause cost distortions.
Interactive Tool
Calculate POHR from estimated overhead and activity base, then compare actual vs. applied overhead to identify under- or overapplied variances.
POHR & Overhead Variance Calculator
Pre-filled with ABC Coffee Shop data. Calculate the predetermined overhead rate from estimated MOH and activity base, then compare actual vs. applied overhead to find under- or overapplied amounts.
Step 1 — Calculate POHR
Predetermined Overhead Rate
$18.00/DLH
$36,000.00 ÷ 2,000 = POHR
Overhead Applied per Unit
$0.450/unit
$18.00 × 0.025 DLH/unit
Step 2 — Actual vs. Applied Overhead
Actual MOH
$37,500.00
Applied MOH
$36,000.00
Recalc: $36,000.00 from base
Variance
Underapplied
$1,500.00
INTERPRETATION
Underapplied by $1,500.00: Actual > Applied
Jobs and inventory were understated; COGS was understated. Close variance by debiting COGS (simple method) or prorating to WIP, FG, and COGS.
ABC example: POHR = $36,000 ÷ 2,000 DLH = $18.00/DLH · Per cup (0.025 DLH) = $0.45/cup · Actual $37,500 vs. Applied $36,000 = Underapplied $1,500
Full Overhead Application Walkthrough: ABC Coffee Shop
| Step | Calculation | Result |
|---|---|---|
| 1. Estimate MOH | Fixed $33,500 + Variable ~$2,500 | $36,000 |
| 2. Estimate DL hours | 85,000 cups × 0.025 hrs/cup | 2,125 hrs |
| 3. Calculate POHR | $36,000 ÷ 2,000 DLH | $18.00/DLH |
| 4. Apply per cup | $18.00 × 0.025 DLH | $0.45/cup |
| 5. Year-end actual | Rent, utilities, indirect labor | $37,500 |
| 6. Total applied | POHR × actual DLH used | $36,000 |
| 7. Variance | Actual − Applied | Underapplied $1,500 |
Common Mistakes
Mistake 1: Using Actual Overhead Rates During the Year
❌ Wrong
Waiting until year-end to divide actual MOH by actual activity — product costs unavailable for pricing decisions all year.
✅ Right
Set the POHR before the period using budgeted MOH and estimated activity. Apply overhead continuously during production.
Mistake 2: Confusing Overapplied with Underapplied
❌ Wrong
Saying overhead is underapplied when applied ($520K) exceeds actual ($500K) — reverses the adjustment direction.
✅ Right
Applied > Actual = Overapplied (COGS too high). Actual > Applied = Underapplied (COGS too low).
Mistake 3: Choosing the Wrong Activity Base
❌ Wrong
Using direct labor hours when overhead is driven by machine setups — distorts product costs and hides true profitability.
✅ Right
Match the activity base to what actually causes overhead. Consider ABC for multiple overhead drivers.
Key Takeaway
Overhead application uses a predetermined overhead rate (POHR) to assign indirect manufacturing costs to products as they are produced. The POHR is based on estimated overhead and an activity base, chosen before the period. Actual overhead will almost never equal applied overhead — the difference is over- or underapplied overhead, which must be closed (usually to COGS or prorated to inventories). A well-designed overhead application system uses a reasonable activity base and produces stable, decision-useful product costs; a poorly designed one distorts profitability and hides cost-control issues.
Test Your Understanding
POHR calculation, overhead application, and variance interpretation — check your answers below.
Question 1: Estimated MOH = $240,000. Estimated machine hours = 30,000. What is the POHR?
Question 2: Actual overhead = $500,000. Applied overhead = $520,000. How is overhead described?
Ready to Practice?
Calculate POHR, apply overhead to jobs, and analyze under- and overapplied variances in the Practice Lab.
Try the Practice LabWhat's Next?
Cost of Goods Manufactured — How all manufacturing costs flowing through Raw Materials, WIP, and Finished Goods combine into the Cost of Goods Manufactured schedule.
Cost of Goods Manufactured
The COGM schedule and cost flow
Manufacturing Overhead
Indirect production costs