8 2 Under- or Over-Applied Overhead Financial and Managerial Accounting

This means that without the adjustment, the manufacturing overhead account will have a credit balance of $500 at the end of the period. Hence, we need to make the journal entry for the overapplied overhead of $500 by debiting that amount into the manufacturing overhead account to zero it out. Likewise, it needs to debit the manufacturing overhead account as in the journal entry above.

Learning Outcomes

• We leave the more complicated procedure of allocating overhead balances to inventory accounts to textbooks on cost accounting.
• Both situations can distort financial statements, but they require different corrective actions.
• These can be useful in assessing capital budgeting decisions and the allocation of limited resources from time, money, and human capital.
• To adjust for this, an entry is made to debit the manufacturing overhead account and credit the cost of goods sold (COGS) account.
• In these situations, the use of a standard overhead rate will result in overapplied overhead.

In this case we would, debit the factory overhead account and credit the cost of goods sold account for the difference. Overapplied factory overhead occurs when the estimated overhead costs used in the predetermined rate calculation are higher than the actual overhead costs incurred. This can happen due to various reasons, such as a decrease in the actual level of activity, changes in cost drivers, or inaccurate estimates used in the predetermined rate calculation.

Implications for Cost Accounting

Because accountants have to charge expenses as they’re incurred, manufacturers don’t have the luxury of waiting until the end of an accounting period to determine their exact manufacturing overhead costs. Instead, they start with estimates based on past experience and their expectations for the future. A company might estimate that for the coming year, it will have manufacturing overhead of $250,000 and it will run its machines for a total of 13,000 hours. While overhead is applied to production on the basis of the predetermined overhead rate, accounting must be completed for the actual invoices related to manufacturing overhead as they are received by the company.

Underapplied and Overapplied Overhead

• A clearing account is used to hold financial data temporarily and is closed out at the end of the period before preparing financial statements.
• Recording the application of overhead costs to a job is further illustrated in the T- accounts that follow.
• Figure 2.6 shows the manufacturing overhead applied based on the six hours worked by Tim Wallace.
• This will result in an excess charge of $15,000 to the cost of goods sold, if the situation is not corrected.
• Such discrepancies can complicate financial analysis and decision-making processes, particularly when it comes to securing financing or evaluating the company’s liquidity.
• Notice that total manufacturing costs as of May 4 for job 50 are summarized at the bottom of the job cost sheet.

This adjustment reduces the COGS, aligning it more closely with the actual costs incurred during the period. By doing so, the gross profit and net income figures on the income statement are corrected, providing a more accurate representation of the company’s profitability. Divide the applied overhead balance in each account by the total amount of applied overhead. However, at the end of the quarter, it emerges that the machines ran for 7,000 hours resulting in $70,000 worth of costs. Advancements in electronic inventory and production management systems have greatly eased the burden of comprehensive operational reporting, often including underapplied overhead analysis. Job order costing and overhead allocation are not new methods of accounting and apply to governmental units as well.

Overapplied Overhead

If the department is expected to increase production in a particular month or quarter, and overhead costs are increased proportionately, this also could lead to overapplied overhead. The price of materials per unit may decrease as the department purchases more goods, which the manager may not have factored into her allocation of overhead funds. In other words, it costs less to produce a single product when a department is making 1,000 rather than 100. Overhead costs are the indirect costs of running a business, such as supplies, lighting and other utilities.

AUD CPA Practice Questions: Applying Professional Skepticism and Judgment

For instance, an inflated gross profit margin might suggest higher operational efficiency than what is actually the case, potentially misleading investors and management. Learn effective strategies for managing overapplied overhead in cost accounting and its impact on financial statements. Over the long-term, the use of a standard overhead rate should result in some months in which overhead is overapplied, and some months in which it is underapplied. On average, however, the amount of overhead applied should approximately match the actual amount of overhead incurred. Likewise, the costs of renovations or renting facilities may fall below the estimated costs.

Analyzing underapplied overhead takes on greater significance for certain businesses such as manufacturing. Often as part of standard financial planning and analysis (FP&A) activities, careful review on underapplied overhead can point to meaningful changes in operational and financial conditions. These can be useful in assessing capital budgeting decisions and the allocation of limited resources from time, money, and human capital. We need to determine what percentage of the applied overhead is in each of the accounts.

The goal is to allocate manufacturing overhead costs to jobs based on some common activity, such as direct labor hours, machine hours, or direct labor costs. The activity used to allocate manufacturing overhead costs to jobs is called an allocation base7 . The predetermined overhead rate8 is calculated prior to the year in which it is used in allocating manufacturing overhead costs to jobs. Sometimes the estimate is more than the actual amount and sometimes it’s less than the actual amount. Overapplied overhead happens when the estimated overhead that was allocated to jobs during the period is actually more than the actual overhead costs that were incurred during the production process. In a sense, the production managers came in “under budget” and achieved a lower overhead than the cost accountants estimated.

Notice that total manufacturing costs as of May 4 for job 50 are summarized at the bottom of the job cost sheet. As you’ve learned, the actual overhead incurred during the year is rarely equal to the amount that was applied to the individual overapplied overhead jobs. Thus, at year-end, the manufacturing overhead account often has a balance, indicating overhead was either overapplied or underapplied. On the other hand, the underapplied overhead is the result of the applied manufacturing overhead cost is less than the actual overhead cost that incurs during the accounting period. Other examples of actual manufacturing overhead costs include factory utilities, machine maintenance, and factory supervisor salaries. All these costs are recorded as debits in the manufacturing overhead account when incurred.