Managing Overapplied Overhead in Cost Accounting

At the end of the year, it found that actual overhead was $74,000 and manufacturing required 24,000 machine hours. (Figure)When setting its predetermined overhead application rate, Tasty Box Meals estimated its overhead would be $100,000 and would require 25,000 machine hours in the next year. At the end of the year, it found that actual overhead was $102,000 and required 26,000 machine hours.

• This means the budgeted amount is less than the amount the business actually spends on its operations.
• This adjustment reduces the COGS, aligning it more closely with the actual costs incurred during the period.
• Underapplied overhead occurs when a business doesn’t budget enough for its overhead costs.
• A journal entry must be made at the end of the period to reconcile the difference between the estimated amount and the actual overhead costs.
• Likewise, the costs of renovations or renting facilities may fall below the estimated costs.

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Shutting off lights or equipment when not in use may also lead to a lower energy bill, which in turn leads to overapplied overhead. However, during the course of the year, production is more efficient than expected, and actual overhead costs only total $950,000. For example, based on estimation, we credit $10,000 into the manufacturing overhead account to assign the overhead cost to the work in process. However, the actual overhead cost overapplied overhead which is debited to the manufacturing overhead account is only $9,500. This process is done by estimating a predetermined overhead rate that can be used to split costs between jobs and departments. At the end of the period, the estimated costs and the actual costs incurred are compared.

Facilities Costs

In order to calculate the amount of overhead applied, a company must first ascertain the predetermined overhead rate. The company’s predetermined overhead rate is calculated at the beginning of the year and is based on the annual estimated overhead and the amount of an allocation base. To determine overapplied overhead, one must first understand the components involved in overhead allocation. Overhead costs include indirect expenses such as utilities, depreciation, and maintenance, which are not directly traceable to specific products. These costs are allocated to products using a predetermined overhead rate, often based on direct labor hours, machine hours, or another activity driver. This rate is established at the beginning of the accounting period based on estimated overhead costs and estimated activity levels.

This discrepancy can lead to distorted financial statements and misinformed decision-making if not properly addressed. This means that a company comes in under budget and achieves a lower amount of overhead costs during the accounting period. A journal entry must be made at the end of the period to reconcile the difference between the estimated amount and the actual overhead costs.

Managing Overapplied Overhead in Cost Accounting

Overapplied factory overhead represents a surplus of allocated costs that were not actually incurred during the period. It can impact the accuracy of product costs and may result in distorted profitability analysis. Therefore, it’s important for companies to monitor and analyze the overapplied overhead variances, identify the reasons behind the deviation, and take appropriate corrective actions to address the issue. Effective management of overapplied overhead requires a combination of proactive planning and continuous monitoring.

7: Determine and Dispose of Underapplied or Overapplied Overhead

• Since overhead costs are initially allocated to inventory, an overapplication results in higher inventory valuations.
• Once the cost accountant determines whether overhead is over or under applied, the account is closed and the over or under applied amount is accounted for in one of two ways.
• Advanced software tools like SAP and Oracle can facilitate this process by providing real-time data and analytics, enabling more informed decision-making.
• This could involve decreasing the cost of goods sold, or adjusting other inventory accounts depending on the company’s accounting policy.
• 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.
• The management of overapplied overhead has far-reaching implications for cost accounting practices within an organization.
• Overapplied overhead often signals that the predetermined overhead rate may need adjustment.

Applied overhead is the overhead allocated to a specific department in a business, based on expected overhead costs. As the company goes about its business making products, its accountants will charge manufacturing overhead expenses to inventory based on the number of machine hours used in production and the estimated rate. Say that over the course of the year, the company winds up running its machines for a total of 15,000 hours.

Implications for Cost Accounting

Understanding the distinction between overapplied and underapplied overhead is fundamental for effective cost management. While overapplied overhead occurs when allocated costs exceed actual costs, underapplied overhead is the opposite scenario, where actual costs surpass the allocated amounts. Both situations can distort financial statements, but they require different corrective actions. Underapplied overhead typically results in understated COGS and inventory values, leading to lower reported profits.

At the end of the accounting period, the balance (whether it’s underapplied or overapplied) is usually cleared out to zero by adjusting the cost of goods sold or other relevant accounts. At the end of the year, with the full benefit of hindsight, the company knows what its actual factory overhead expenses have been. If the actual overhead had come to $270,000, the company would have charged off more than was necessary, and it would have “overapplied overhead” of $18,450. Adjusting journal entries are necessary to correct the financial distortions caused by overapplied overhead.