Underapplied Overhead

From CEOpedia | Management online
Underapplied Overhead
See also

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[1].

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.

There are two types of overhead variance[2][3]:

  • 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[4].

Footnotes

  1. S. Crosson, B. Needles 2010, p.78
  2. M.M. Mowen, D.R. Hansen 2011, p.167
  3. J. Heintz, R. Parry 2007, p.323
  4. D.L. Heitger, M.M. Mowen 2010, p.151

References

Author: Brygida Mordarska