Underapplied Overhead occurs when actual overhead costs are higher than overhead applied to jobs. If the overhead costs applied to production during the period are less than the actual overhead costs, the difference represents underapplied overhead costs. The Cost of Goods Sold or Cost of Sales account is debited or increased and the Overhead account is credited or decreased by this difference, assuming that the difference is not material.
Cost of Goods Sold
If actual overhead is greater than applied overhead, then the variance is called underapplied overhead. If actual overhead is less than applied overhead, then the variance is called overapplied overhead. The cost appears lower than it really is. Conversely, if overhead has been overapplied, then product cost has been overstated. The cost higher than it really is.
Because it is impossible to perfectly estimate future overhead costs and production activity, overhead variances are virtually inevitable. However, at year-end, costs reported on the financial statements must be actual amounts. Thus, something must be done with the overhead variance. Usually, the entire overhead variance is assigned to Cost of Goods Sold. This practice is justified on the basis of materiality, the same principle used to justify expensing the entire cost of a stapler. Since the overhead variance is usually relatively small, and all production costs should appear in cost of goods sold eventually, the method of disposition is not a critical matter.
- Underapplied overhead is added to Cost of Goods Sold
- Overapplied overhead is subtracted from Cost of Goods Sold
Reconciling Applied Overhead with Actual Overhead
Recall that two types of overhead must be taken into consideration. One is actual overhead, and those costs are tracked throughout the year in the overhead account. The second type is applies overhead. Overhead applied to production is computed throughout the year and is added to actual direct materials and actual direct labor to get total product cost. At the end of the year, however, it is time to reconcile any difference between actual and applied overhead and to correct the cost of goods sold account to reflect actual overhead spending.
Suppose that Proto Company had actual overhead $400,000 for the year but had applied $390,000 to production. Notice that the amount of overhead applied to production ($390,000) differs from the actual overhead ($400,000). Since the predetermined overhead rate is based on estimated data, applied overhead will rarely equal actual overhead. Since only $390,000 was applied in our example, the firm has underapplied overhead by $10,000. If applied overhead had been $410,000, then too much overhead would have been applied to production. The firm would have overapplied overhead by $10,000.
The difference between actual overhead and applied overhead is called an overhead variance. If actual overhead is greater than applied overhead, ten the variance is called underapplied overhead. If actual overhead is less than applied overhead, then the variance is called overapplied overhead.
Examples of Underapplied Overhead
- Overhead is allocated to jobs based on estimates rather than actual costs. If the actual costs are higher than the estimated costs, the difference is considered underapplied overhead. For example, if a company estimated that it would require $50,000 in overhead costs to produce a certain product, but the actual costs were $60,000, then the underapplied overhead would be $10,000.
- If a company experiences a period of inactivity, it can result in underapplied overhead. For example, if a company shuts down operations for a month due to a holiday, the overhead costs associated with that period may not be allocated to any production jobs, resulting in underapplied overhead.
- If a company underestimates its estimated overhead costs, this can also result in underapplied overhead. For example, if a company estimated that it would require $20,000 in overhead costs to produce a certain product, but the actual costs were $30,000, then the underapplied overhead would be $10,000.
Advantages of Underapplied Overhead
Underapplied Overhead has several advantages, including:
- Improved accuracy in cost accounting as costs are accurately allocated to the production process.
- Enhanced cost control, as it helps to identify cost overruns and avoid over- or under-spending on overhead costs.
- Helps to maintain accurate records of overhead costs, allowing for better budgeting and forecasting.
- Allows for more accurate pricing of products, as accurate overhead costs can be included in the cost of production.
- Can be used to analyze the cost of production and identify areas for improvement.
Limitations of Underapplied Overhead
Underapplied overhead can lead to several limitations when accounting for expenses. These limitations include:
- Misallocated expenses: Underapplied overhead may lead to expenses being allocated inaccurately, resulting in incorrect cost calculations for certain jobs.
- Unclear reporting: Underapplied overhead can also lead to unclear reporting of expenses, as the actual expenses may not be known until after the period has ended.
- Inaccurate budgeting: When underapplied overhead occurs, it can lead to inaccurate budgeting and forecasting, as the exact costs of production may not be known until after the period has ended.
- Unbalanced books: Lastly, underapplied overhead can lead to unbalanced books, as the expenses will not be accurately reflected in the financial statements.
These alternative approaches include:
- Allocating the Underapplied Overhead to Work in Progress (WIP) or Finished Goods Inventory (FGI). This approach is useful when the underapplied overhead costs are expected to be recovered in future production. The WIP or FGI account is debited and the Overhead account is credited.
- Allocating the Underapplied Overhead to Cost of Sales/Cost of Goods Sold. This approach is useful when underapplied overhead costs are not expected to be recovered in future production. The Cost of Sales/Cost of Goods Sold account is debited and the Overhead account is credited.
- Allocating the Underapplied Overhead to a separate account such as Underapplied Overhead. This approach is useful when the underapplied overhead costs are expected to be recovered in future production or when the underapplied overhead costs are not expected to be recovered in future production. The Underapplied Overhead account is debited and the Overhead account is credited.
In summary, there are several alternative approaches to allocating Underapplied Overhead. These include allocating to WIP/FGI, Cost of Sales/Cost of Goods Sold, or a separate Underapplied Overhead account, depending on the expected recovery of the underapplied overhead costs.
- S. Crosson, B. Needles 2010, p.78
- M.M. Mowen, D.R. Hansen 2011, p.167
- J. Heintz, R. Parry 2007, p.323
- D.L. Heitger, M.M. Mowen 2010, p.151
- Crosson S., Needles B., (2010), Managerial Accounting, Cengage Learning, Canada.
- Heintz J., Parry R., (2007), Accounting, Cengage Learning, Brazil.
- Heitger D.L., Mowen M.M, (2010), Fundamental Cornerstones of Managerial Accounting, Cengage Learning, Singapore.
- Mowen M.M, Hansen D.R., (2011), Cornerstones of Managerial Accounting, Cengage Learning, Brazil.
Author: Brygida Mordarska