Costing overheads is the process of assigning indirect production and operating costs, the ones that cannot be traced to a single unit of output, onto cost objects through an allocation base and a predetermined overhead rate. The rate is budgeted overhead divided by the budgeted volume of that base, and overhead is applied by multiplying the rate by the base activity each cost object actually consumes. The costs are the overhead; costing them is the separate act of deciding where they land. The same process surfaces as overhead absorption in UK and Commonwealth material, where the rate is called an overhead absorption rate.
The Predetermined Overhead Rate
Both inputs to the rate are budgeted, not actual, which is the whole point of the method. A job has to be costed while it is running, long before anyone knows what the period’s overhead really came to.
Predetermined rate = budgeted overhead / budgeted activity in the allocation base
Applied overhead = predetermined rate x actual activity in the baseOnce the rate is set, the only thing that varies job to job is the actual base activity, so two jobs with identical machine hours carry identical overhead from that pool whatever else happened around them.
The denominator is not a free choice on the books. Variable production overheads are allocated to each unit of production on the basis of the actual use of the production facilities, while the allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities (Accounting Research Bulletin No. 43, Chapter 4, paragraph 5, as amended by FASB Statement No. 151). For the fixed half of the pool, that fixes the denominator at normal capacity, which is the production expected across a number of periods or seasons under normal circumstances rather than whatever this period’s budget happens to be. The judgment about when production falls below that range, along with the split of the resulting gap, is worked through in 2-way variance analysis.
Choosing the Allocation Base
The base should be the activity that actually drives the pool, and the tax rules name the candidates directly. The factors that may be used in developing a burden rate include the selection of an appropriate level of activity and a period of time on which to base the calculation, the selection of an appropriate statistical base such as direct labor hours, direct labor dollars, machine hours, or a combination of them, and the appropriate budgeting, classification and analysis of expenses, for example the analysis of fixed versus variable costs (Treasury Regulation 1.263A-1(f)(3)(i)(B)).
Machine hours suit a pool made of depreciation, power and equipment maintenance, because those costs move when the machines run. Direct labor hours suit a pool that follows people, such as supervision and factory occupancy in an assembly operation. Direct labor dollars suit the same pool when seniority, not time, is what varies across jobs. None of it has to be one rate. A taxpayer may allocate different indirect costs on the basis of different burden rates, using one rate for rent and another for utilities (Treasury Regulation 1.263A-1(f)(3)(i)(A)), so a pool that fails the single-driver test is usually a pool that should be split rather than a base that should be compromised.
Changing that choice is heavier than it looks. A periodic adjustment to a burden rate that merely reflects current operating conditions, such as increases in automation or changes in operation or prices, is not a change in method of accounting under section 446(e), but a change in the concept or base on which the rates are developed, such as a change from basing them on direct labor hours to basing them on direct machine hours, is a change in method of accounting (Treasury Regulation 1.263A-1(f)(3)(i)(A)).
What Does a 20% Overhead Rate Mean?
A rate quoted as a percentage is telling you the allocation base is measured in dollars rather than in hours. Say the base is direct labor dollars. 20% of them applies overhead in proportion to the labor cost a job carries, so a job staffed with senior people absorbs more of the pool than a job that took the same hours from junior people. A rate per machine hour answers the opposite way, and neither is more correct than the other until you know what the pool is made of.
A Worked Example
Say a manufacturer sets its rate on machine hours and the year closes on the figures below.
Budgeted overhead $480,000
Budgeted machine hours 24,000
Predetermined rate 480,000 / 24,000 = $20.00 per machine hour
Actual machine hours 23,000
Applied overhead 23,000 x 20.00 = $460,000
Actual overhead incurred $472,000
Under-applied overhead 472,000 - 460,000 = $12,000The gap is the difference between what the rate put onto the products and what the period actually cost. Why it opened, spending or volume, is a variance question. Where it goes now is a costing question, and it has two different answers.
Under-Applied and Over-Applied Overhead at Period End
On the books, the part of the pool the rate failed to absorb because production ran below normal capacity does not stay in inventory. Unallocated overheads are recognized as an expense in the period in which they are incurred, and in periods of abnormally high production the amount of fixed overhead allocated to each unit of production is decreased so that inventories are not measured above cost (Accounting Research Bulletin No. 43, Chapter 4, paragraphs 5 and 5A, as amended by FASB Statement No. 151). Both halves push the same way: the balance sheet is protected first, and the income statement takes what the units could not.
The tax answer runs the other direction. Any net negative or net positive difference between the total predetermined amount of costs allocated to property and the total amount of indirect costs actually incurred and required to be allocated to that property, which is the under or over-applied burden, must be treated as an adjustment to the taxpayer’s ending inventory or capital account in the taxable year in which the difference arises. If the adjustment is not significant in amount in relation to total indirect costs incurred for the year, it need not be allocated unless that allocation is made in the taxpayer’s financial statement, and positive and negative adjustments must be treated consistently (Treasury Regulation 1.263A-1(f)(3)(i)(C)).
So a client that closes its whole under-applied balance to cost of goods sold may have answered the book question and has certainly left the tax one open, because the regulation sends that balance back into ending inventory unless the significance test releases it.
Where the Tax Rules Pull a Broader Set of Costs
Book capitalization asks which production overhead attaches to units at normal capacity. Section 263A asks a wider question. Indirect costs are defined as all costs other than direct material costs and direct labor costs in the case of property produced, or acquisition costs in the case of property acquired for resale, and a taxpayer subject to section 263A must capitalize all indirect costs properly allocable to that property, meaning the costs that directly benefit or are incurred by reason of the performance of production or resale activities (Treasury Regulation 1.263A-1(e)(3)(i)(A)).
The regulation then names examples that a factory overhead pool would not normally hold. Officers’ compensation is on the list. Purchasing costs, handling costs and storage costs each appear as separate items, so three functions that sit well away from the production floor still have to be tested. Pension and other related costs are there, and so are capitalizable service costs, a class the regulation illustrates with general and administrative costs while leaving deductible service costs, the overall management and policy guidance layer, outside the capitalized pool (Treasury Regulation 1.263A-1(e)(3)(ii) and (e)(4)).
On the books that same layer is treated differently. General and administrative expenses should under most circumstances be included as period charges, except for the portion that may be clearly related to production and so forms part of inventory cost, and selling expenses constitute no part of inventory costs (Accounting Research Bulletin No. 43, Chapter 4, paragraph 5A, as amended by FASB Statement No. 151). Section 263A agrees about selling, since selling and distribution costs, which the regulation defines as marketing, selling, advertising and distribution costs, are not required to be capitalized (Treasury Regulation 1.263A-1(e)(3)(iii)(A)). The divergence is the middle layer, where the book test asks whether a cost is clearly related to production and the tax test asks whether it directly benefits or is incurred by reason of production or resale.
Two scope facts decide whether any of it reaches a given client. A taxpayer other than a tax shelter that meets the gross receipts test under section 448(c) is not required to capitalize costs under section 263A for real or tangible personal property produced, or property described in section 1221(a)(1) acquired for resale, during that year (Treasury Regulation 1.263A-1(j)(1)). And property produced under a long-term contract sits outside section 263A altogether, apart from certain home construction contracts described in section 460(e)(1) (Treasury Regulation 1.263A-1(b)(2)); the allocation rules that take over there are the ones set out in construction bookkeeping.
What Costing Overheads Is Confused With
Overhead Costing and Overhead
Overhead names the category of cost. Costing overheads names the process that moves that category onto cost objects. A firm can settle exactly what belongs in the pool and still be undecided on the base, the rate and the period-end disposition, which is why the two questions never collapse into one.
Absorption Costing and Variable Costing
Absorption costing carries fixed production overhead into unit cost. Variable costing charges all of it to the period, which keeps it an internal management view rather than a basis for the inventory figure, because the allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities (Accounting Research Bulletin No. 43, Chapter 4, paragraph 5, as amended by FASB Statement No. 151). The outer guardrail on the same page is that excluding all overheads from inventory costs is not an accepted accounting procedure.
Overhead Applied and Overhead Incurred
Applied overhead is a computed figure, the rate multiplied by the base activity. Incurred overhead is what the pool actually cost. They match only by coincidence, and naming which one a management report means is the difference between a costing question and a variance question. The split of the gap between them belongs to 2-way variance analysis.
The Book Pool and the 263A Pool
These are two computations, not one plus an adjustment. A workpaper that starts from book overhead absorbed and adds a plug has not put the regulation’s test to each cost, and that is the single most common place a costing method survives review on the books and fails it on the return.
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