4 6: Determine and Dispose of Underapplied or Overapplied Overhead Business LibreTexts

Companies use overhead analysis to determine their efficiency during a period of controlling overhead costs. Overapplied overhead occurs when the total amount of factory overhead costs assigned to produced units is more than was actually incurred in the period. This usually happens when a business uses a standard long-term overhead rate that is based on the average amount of factory overhead that is likely to be incurred, and the average number of units produced.

Manufacturing Overhead

Instead, management needs to estimate the future overhead costs and allocate them throughout the production process. As noted above, underapplied overhead is reported on a company’s balance sheet as a prepaid expense or a short-term asset. 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. 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.

• If, at the end of the term, there is a debit balance in manufacturing overhead, the overhead is considered underapplied overhead.
• While overapplied overhead occurs when allocated costs exceed actual costs, underapplied overhead is the opposite scenario, where actual costs surpass the allocated amounts.
• Subtract the budgeted overhead costs from the actual overhead costs to determine the applied overhead.
• A debit balance in manufacturing overhead shows either that not enough overhead was applied to the individual jobs or overhead was underapplied.
• Likewise, it needs to debit the manufacturing overhead account as in the journal entry above.

Underapplied Overhead vs. Overapplied Overhead

In financial terms, overapplied overhead results in a credit balance in the overhead account. This means that without the adjustment, the manufacturing overhead account will have a credit balance can freshbooks do taxes of $500 at the end of the period. Hence, we need to make the journal entry for the overapplied overhead of $500 by debiting that amount into the manufacturing overhead account to zero it out.

Managing Overapplied Overhead in Cost Accounting

This could involve decreasing the cost of goods sold, or adjusting other inventory accounts depending on the company’s accounting policy. This will ensure the company’s financial statements accurately reflect the actual overhead costs incurred during the period. As the manufacturing overhead costs that are applied to the production are based on the estimation, it rarely is equal to the actual overhead cost that really occurs during the period. In some cases, the overapplied overhead may also be allocated to work-in-process (WIP) inventory and finished goods inventory accounts, depending on where the overhead costs were initially applied. Adjusting entries in these accounts involve debiting the manufacturing overhead account and crediting the respective inventory accounts.

For instance, an inflated gross profit margin might suggest higher operational efficiency than what is actually the case, potentially misleading investors and management. 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 which is debited to the manufacturing overhead account is only $9,500. However, during the course of the year, production is more efficient than expected, and actual overhead costs only total $950,000.

Financial and Managerial Accounting

This approach helps in identifying inefficiencies and areas for cost reduction, ultimately leading to more accurate overhead allocation. If the company booked $4,000 of estimated overhead at the beginning of the quarter, it would have to reverse the overapplied overhead, so estimated overhead booked matches the actual overhead incurred for the period. On the other hand, the underapplied overhead is the result of the applied manufacturing overhead cost is less than the actual overhead cost that incurs during the accounting period. As you’ve learned, the actual overhead incurred during the year is rarely equal to the amount that was applied to the individual jobs.

Put simply, the business went over budget making the cost of goods sold more than expected. 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. In this case we would, debit the factory overhead account and credit the cost of goods sold account for the difference. Another strategy involves leveraging technology for real-time data analysis and monitoring.

The opposite of overapplied overhead is underapplied overhead, which occurs when a company has applied more overhead to products than it has actually incurred. Similarly, the work in process inventory account and finished goods inventory account will also be added in the overapplied overhead journal entry. Learn effective strategies for managing overapplied overhead in cost accounting and its impact on financial statements. Over the long-term, the use of a standard overhead rate should result in some months in which overhead is overapplied, and some months in which it is underapplied.