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. 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. That figure is the company’s “applied” overhead, the amount assigned to items in inventory.

• Carbonic Corporation uses an overhead application rate that resulted in $15,000 of excess overhead being charged to produced units during its March reporting period.
• See it applied in this 1992 report on Accounting for Shipyard Costs and Nuclear Waste Disposal Plans from the United States General Accounting Office.
• Underapplied overhead occurs when a business doesn’t budget enough for its overhead costs.
• For example, the manufacturing company ABC finds that it has a $2,000 debit balance of the manufacturing overhead at the end of the accounting period.
• If actual overhead costs per hour are given, then multiply those costs per hour by the number of hours worked.

6 Determine and Dispose of Underapplied or Overapplied Overhead

Overapplied overhead occurs when the allocated manufacturing overhead costs exceed the actual incurred costs during a specific period. This discrepancy can lead to distorted financial statements and misinformed decision-making if not properly addressed. 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.

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Moreover, overapplied overhead impacts the balance sheet by inflating inventory values. Since overhead costs are initially allocated to inventory, an overapplication results in higher inventory valuations. This can distort the true financial position of the company, as the assets on the balance sheet appear more valuable than they are. Such discrepancies can complicate financial analysis and decision-making processes, particularly when it comes to securing financing or evaluating the company’s liquidity.

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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 electronic filing pin request 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. Thus, at year-end, the manufacturing overhead account often has a balance, indicating overhead was either overapplied or underapplied.

The initial predetermined overhead cost rate is calculated by taking the budgeted overhead costs divided by the budgeted activity. During the course of the year many businesses choose to budget and project future expenses. This helps management plan for cash flows throughout the year as well as establish goals.

What is Overapplied Overhead?

Analyzing 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.

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. This ensures that the inventory valuations on the balance sheet are accurate, reflecting the true cost of production. Once the period concludes, actual overhead costs and actual activity levels are recorded. The next step involves comparing the allocated overhead, calculated using the predetermined rate, to the actual overhead incurred.

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. In this case, the manufacturing overhead is overapplied by $500 ($10,000 – $9,500) as the applied overhead cost is $500 more than the actual overhead cost that have occurred during the period. To correct for overapplied overhead, the excess amount is usually subtracted from the total cost of goods sold. If the amount of overapplied overhead is significant, it may be spread out across various inventory accounts and cost of goods sold in proportion to the overhead applied during the period.

This is due to the company needs to prepare the financial statements with the actual costs that really occur during the accounting period rather than the estimation that is based on the predetermined standard rate. As the manufacturing overhead applied during the period is an estimate, there is usually an underapplied or overapplied overhead that needs to be reconciled at the end of the accounting period. 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. This adjustment reduces the COGS, aligning it more closely with the actual costs incurred during the period.