What options are available for disposing of Underapplied or Overapplied overhead?
What Is Underapplied Overhead?The term underapplied overhead refers to a situation that arises when overhead expenses amount to more than what a company actually budgets for in order to run its operations. Underapplied overhead is normally reported as a prepaid expense on a company's balance sheet and is balanced by inputting a debit to the cost of goods sold (COGS) section by the end of the year. Costs of goods sold are the direct cost associated with the production of goods sold by a company. The amount of underapplied overhead is referred to as an unfavorable variance. Show
Key Takeaways
Understanding Underapplied OverheadBefore looking at how underapplied overhead works, it's important to define overhead costs. The term overhead is used to describe the costs associated with running a business. More specifically, these are expenses that a business incurs for its day-to-day operations but are not directly linked to the creation of a product or service. Overhead is important for businesses for a number of reasons including budgeting and how much to charge their customers in order to realize a profit. Underapplied overhead occurs when a business doesn't budget enough for its overhead costs. This means the budgeted amount is less than the amount the business actually spends on its operations. For example, when a company incurs $150,000 in overhead after budgeting only $100,000, it has an underapplied overhead of $50,000. This is referred to as an unfavorable variance because it means that the budgeted costs were lower than actual costs. Put simply, the business went over budget making the cost of goods sold more than expected. As noted above, underapplied overhead is reported on a company's balance sheet as a prepaid expense or a short-term asset. This debit item on the balance sheet must be offset at a future date. In order to reconcile this, the company's accounting department generally inputs a debit by the end of the year to the COGS section and a credit to the prepaid expenses section. When underapplied overhead appears on financial statements, it is generally not considered a negative event. Rather, analysts and interested managers look for patterns that may point to changes in the business environment or economic cycle. Should unfavorable variance or outcomes arise—because not enough product was produced to absorb all overhead costs incurred—managers will first look for viable reasons. These may be explained by expected hiccups in production, business, or seasonal variation. The initial predetermined overhead cost rate is calculated by taking the budgeted overhead costs divided by the budgeted activity. Special ConsiderationsAnalyzing 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. Advancements in electronic inventory and production management systems have greatly eased the burden of comprehensive operational reporting, often including underapplied overhead analysis. These improvements allow managers to better assess key operational metrics. Underapplied Overhead vs. Overapplied OverheadUnderapplied overhead is the opposite of overapplied overhead. Overapplied overhead occurs when expenses incurred are actually less than what a company accounts for in its budget. This means that a company comes in under budget and achieves a lower amount of overhead costs during the accounting period. Businesses must account for overapplied overheads as well. This is recorded in the opposite manner that underapplied overhead is on the balance sheet—first noted as a credit to the overhead section, which is then offset by a credit on the COGS section and debit on the overhead section by the end of the fiscal year.
Learning objective of the article: How is over and under applied overhead is disposed off. Give an example to explain the procedure? What disposition should be made of an underapplied overhead or overapplied overhead balance remaining in the manufacturing overhead account at the end of a period? Generally any balance
in the account is treated in one of the two ways. Closed out to cost of goods sold. Allocated
between work in process (WIP), finished goods and cost of goods sold in proportion to the overhead applied during the current period in the ending balances of these account. The second method, which allocates the under or overapplied overhead among ending inventories and cost of goods sold is equivalent to using an “actual” overhead rate and is for that reason considered by many to be more accurate than the first method. Consequently, if the amount of underapplied or overapplied overhead is material, many accountants would insist that the second method be used. Closed Out to Cost of Goods Sold:Closing out the balance in manufacturing overhead account to cost of goods sold is simpler than the allocation method. Where the overhead is underapplied following journal entry is made:
Where the overhead is overapplied the following journal entry is made:
After passing one of these journal entries, cost of goods sold is adjusted. Consequently cost of goods sold is increased by the amount of underapplied and decreased by the amount of overapplied overhead. Example:
Allocated Between Accounts:Allocation of under or overapplied overhead between work in process (WIP), finished goods and cost of goods sold (COGS) is more accurate than closing the entire balance into cost of goods sold. The reason is that allocation assigns overhead costs to where they would have gone in the first place had it not been for the errors in the estimates going into the predetermined overhead rate. Example:If the amount of under-applied or over-applied overhead is significant, it should be allocated among the accounts containing applied overhead: Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. A significant amount of “under-applied” or “over-applied” overhead means that the balances in these accounts are quite different from what they would have been if actual overhead costs had been assigned to production. Allocation restates the account balances to conform more closely to actual historical cost as required for external reporting by generally accepted accounting principles. The above figure uses assumed data for the Cutting and Mounting Department to illustrate the proration of over-applied overhead among the necessary accounts; had the amount been under-applied, the accounts debited and credited in the journal entry would be the reverse of that presented for over-applied overhead. A single overhead account is used in this illustration. Theoretically, under-applied or over-applied overhead should be allocated based on the amounts of applied overhead contained in each account rather than on total account balances. Use of total account balances could cause distortion because they contain direct material and direct labor costs that are not related to actual or applied overhead. In spite of this potential distortion, use of total balances is more common in practice for two reasons: First, the theoretical method is complex and requires detailed account analysis. Second, overhead tends to lose its identity after leaving Work in Process Inventory, thus making more difficult the determination of the amount of overhead in Finished Goods Inventory and Cost of Goods Sold account balances You may also be interested in other useful articles from “job order costing system” chapter:
About The AuthorAbidaWhat methods can be used to dispose of Underapplied or Overapplied?What methods can be used to dispose of underapplied or overapplied manufacturing overhead? Close it to Cost of goods sold. Allocate it to Work in process, Finished goods, and Cost of goods sold.
How do you deal with Overapplied overhead?When overhead has been overapplied, the proper accounting is to debit the manufacturing overhead cost pool and credit the cost of goods sold in the amount of the overapplication. Doing so results in the actual amount of overhead incurred being charged through the cost of goods sold.
How the firm can dispose of under or overallocated overhead costs?One way to dispose of underallocated or overallocated overhead costs at the end of a fiscal year would be to prorate the underallocated or overallocated overhead costs to the work-in- process control account, the finished goods control account, and to the cost of goods sold account based on the relative amounts in each ...
What is Overapplied and Underapplied overhead and how is it accounted for?Overapplied overhead occurs when expenses incurred are actually less than what a company accounts for in its budget. This means that a company comes in under budget and achieves a lower amount of overhead costs during the accounting period. Businesses must account for overapplied overheads as well.
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