The difference between the overhead cost that is estimated and the actual overhead costs of a period is termed as either under-applied overhead or overapplied overhead.
Under-applied overhead describes a situation where the actual amount of overhead expenses exceeds the applied amount of overhead expenses. This means that the rate that was predetermined actually underestimated the overhead costs for the period. As a result, the applied overhead expenses were lower than the actual overhead expenses.
It is called under-applied overhead because the predetermined rate did not apply enough overhead expense for the period.
Over-applied overhead occurs when the applied amount of overhead expenses exceeds the actual amount of overhead expenses. In this situation, the predetermined rate overestimated the overhead costs for the period. Therefore the applied overhead expenses were higher than the actual overhead expenses.
It is called over-applied overhead because the predetermined rate applied too much overhead expense for the period.
Analyzing the difference between actual and applied overheads
The predetermined overhead rate is based entirely on estimated data and is established before an accounting period begins. The predetermined overhead rate provides the figure for the overhead cost that is applied to work in process and will in almost all cases be different from the amount of overhead cost actually incurred during an accounting period.
Any figure based on estimates, even with the best of data and the most skilled operators is likely to be inaccurate to some degree.
The causes and reasons for under or over-applied overhead occurring can be quite complicated. A significant cause of error is that the method of applying overheads using predetermined overhead rate assumes that actual overhead costs will be proportional to the actual amount of the allocation incurred during the period.
If the predetermined overhead rate is calculated to be $25 per hour for the use of a machine it is assumed that actual overhead cost that will be incurred will be $25 for every hour the machine is actually used.
Even if this figure is based on substantial and accurate records of previous use this might not be correct for a couple of reasons:
Influence of fixed costs
When calculating the predetermined overhead rate fixed costs are included and in many cases, much of the overhead consists of fixed costs. These fixed costs do not increase as the number of machine hours incurred increases.
Overhead cost control
If the employees responsible for spending on overheads are diligent and do a good job the costs can be reduced and the costs at the end of the accounting period can be less than anticipated. If they do a poor job the costs will be more than anticipated and management needs to be informed if this were the cause of inaccurately applied overhead.
How to dispose of under-applied or over-applied overhead balances
At the end of an accounting period any under-applied overhead or over-applied overhead balance remaining in the manufacturing overhead account has to be disposed of.
There are generally two ways that this disposition can be effected:
- The under-applied or over-applied overhead balances can be closed out to cost of goods sold
- If there is under-applied overhead these journal entries would be used:
- Cost of goods sold Dr
- Manufacturing overhead Cr
In the event of the overhead is over-applied these following journal entries would be used:
- Manufacturing overhead Dr
- Cost of goods sold Cr
After each of these journal entries there is an adjustment to the cost of goods sold. If there was an amount of under-applied overhead the costs of goods sold would be increased by that amount. If there is over-applied overhead the costs of goods sold is decreased by the amount of over-applied overhead.
The second approach is for the under-applied overhead or over-applied overhead to be allocated between accounts.
Using this method the under-applied overhead or over-applied overhead is allocated between work in process, finished goods and cost of goods sold in proportion to the overhead applied during the current period in the ending balances in each of these accounts.
This method is considered to be more accurate than the costs of goods sold approach because by allocating the under or over-applied overhead amongst the ending inventories and the cost of goods sold is deemed to be equivalent to using an actual overhead rate. Allocation is more accurate than closing the entire balance into cost of goods sold but it is much more complex.
As a consequence many accountants insist that the allocation between accounts method be used if the amount of under-applied or over-applied overhead is material. The concept of materiality within auditing and accounting relates to the importance or significance of an amount, transaction, or discrepancy.
The objective of the reporting of financial statements to management is to enable them to form an opinion of the financial wellbeing of the organisation. This is dependent on whether the financial statements are prepared, in all material respects, to conform with their financial reporting framework. If to learn more aspects of the business have a look at the this link.