Posted in Finance, Accounting and Economics Terms, Total Reads: 458
Definition: Applied Cost
Applied cost is a term widely used in Cost Accounting which refers to the expense on an activity or a product, usually applied according to a pre-determined formula. This applied cost is based on an estimate made generally at the beginning of the accounting period. Since this cost may or may not depend on the actual cost that is incurred, hence this value may under estimate or over-estimate the actual cost incurred.
Since overhead cost cannot be directly traced back to individual cost objects with certainty, a standard methodology is employed based on a historical trend or estimation. For example, a company may choose to allocate the factory overheads based on machine time utilised in that period. If the overhead rate applied is ₹50 per machine hour of usage, Since the total machine hours in the said period was 2500 hours, the company applies an overhead of ₹50x2500 = ₹125,000 for that period on the number of units produced.
This overhead rate is fixed and only changed after long intervals. It may not be in line with the actual overheads incurred in a given period, but overtime this variance must become zero because of seasonality of most of the products’ demand. If the variance does not become zero, then it is time to alter the overhead rate.
This method of Applied Cost may mislead the managers in decision making scenarios. It overestimates the costs in some periods and underestimates in other periods leading to misleading picture on the profitability of individual periods. This leads to making wrong decisions with respect to improving the operations, pricing the products and scheduling the production.