INNOBOX

Although those jobs are still inWork in Process or Finished Goods Inventory, companies usuallyadjust the Cost of Goods Sold account instead of each inventoryaccount. Adjusting each inventory account for a small overheadadjustment is usually not a good use of managerial and accountingtime and effort. All jobs appear in Cost of Goods Sold sooner orlater, so companies simply adjust Cost of Goods Sold instead of theinventory accounts. 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.

Example of Overapplied Overhead

This can affect a company’s perceived financial health and may influence decisions related to pricing, budgeting, and resource allocation. Typically, the overapplied overhead is first recorded in the manufacturing overhead account. To adjust for this, an entry is made to debit the manufacturing overhead account and credit the cost of goods sold (COGS) account.

Calculating the Predetermined Overhead Rate

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.

The Most Common Accounting Treatment of Underapplied Manufacturing Overhead

• Boeing provides products and services to customers in 150 countries and employs 165,000 people throughout the world.
• Thus each job will be assigned $30 in overhead costs for every direct labor hour charged to the job.
• This way, the effects of under- or overapplying overhead do not carry forward into future accounting periods.
• A predetermined overhead rate is computed at the beginning of the period using estimated information and is used to apply manufacturing overhead cost throughout the period.
• When this journal entry is recorded, we also record overhead applied on the appropriate job cost sheet, just as we did with direct materials and direct labor.
• In this case, XYZ Corp. will need to make an adjustment to its accounting records to account for the overapplied overhead.
• As you’ve learned, the actual overhead incurred during the year is rarely equal to the amount that was applied to the individual jobs.

Depending on their production process, companies may express these costs as a rate per hour of machine time, a rate per hour of worker time or a per-unit cost, for example. This way, the effects of under- or overapplying overhead do not carry forward into future accounting periods. The exact method for dealing with underapplied or overapplied overhead can depend on the specific accounting policies and practices of the company. Overhead refers to indirect costs that are not directly tied to a specific activity such as manufacturing or production. These costs are typically applied to products or services using a predetermined overhead rate.

• The occurrence of over or under-applied overhead is normal in manufacturing businesses because overhead is applied to work in process using a predetermined overhead rate.
• The initial predetermined overhead cost rate is calculated by taking the budgeted overhead costs divided by the budgeted activity.
• When overhead is overapplied, it means that the cost of goods sold (COGS) is understated, leading to an inflated gross profit.
• 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.
• If, at the end of the term, there is a credit balance in manufacturing overhead, more overhead was applied to jobs than was actually incurred.
• For example, if a company were to receive a $2,000 invoice for factory electricity, an overhead cost, the company would debit the manufacturing overhead accounting and credit accounts payable for the $2,000.

Company

The entry would debit the Factory Overhead Control account and credit Cost of Goods Sold (or an equivalent expense account). By doing so, the overapplied overhead cost is recognized as a reduction in expenses in the period in which it occurred. Addressing underapplied overhead involves adjusting journal entries to increase COGS and inventory values, thereby aligning them with actual costs. This adjustment ensures that financial statements accurately reflect the company’s expenses and profitability. Regular variance analysis and monitoring are crucial for identifying and correcting both overapplied and overapplied overhead underapplied overhead. By maintaining accurate overhead allocation, companies can improve their financial reporting and make more informed strategic decisions.

Increased Production

This will ensure the company’s financial statements accurately reflect the actual overhead costs incurred during the period. Conversely, if the actual overhead costs incurred exceed the allocated overhead costs, it is referred to as underapplied factory overhead. Thus each job will be assigned $30 in overhead costs for every direct labor hour charged to the job. The assignment of overhead costs to jobs based on a predetermined overhead rate is called overhead applied9. Remember that overhead applied does not represent actual overhead costs incurred by the job—nor does it represent direct labor or direct material costs.

How to Determine Overapplied Overhead in Managerial Accounting

See it applied in this 1992 report on Accounting for Shipyard Costs and Nuclear Waste Disposal Plans from the United States General Accounting Office. Overhead costs include the costs of labor that isn’t directly used to create a product or service being sold. Labor costs for building new facilities, for example, fall into the category of overhead. When allocating funds, business managers don’t always know the specific labor costs for such tasks. For instance, a manager might know that Facility A needs renovations but must hire a professional to determine which specific renovations it needs.