How to Find Underapplied Overhead in Accounting
Ensure your financial statements reflect true production costs. This guide helps you identify a common accounting variance to optimize cost allocation and improve accuracy.
Overhead costs represent indirect expenses incurred during the manufacturing process, such as factory rent, utilities, and indirect labor. Companies initially estimate these costs and allocate them to the products being made. This allocation process allows businesses to determine the full cost of production for each unit. However, the estimated amount allocated to products sometimes differs from the actual overhead costs incurred, creating a variance.
Defining Underapplied Overhead
Underapplied overhead occurs when the actual factory overhead costs incurred exceed the overhead costs applied to production. This situation results in a debit balance within the manufacturing overhead account. This variance is unfavorable, indicating more overhead was spent than anticipated.
This imbalance can arise for several reasons, including actual overhead costs being higher than initially budgeted. It might also happen if the actual activity level, such as machine hours or direct labor hours, was lower than the budgeted activity level used to set the allocation rate. Consequently, products were not charged enough for their share of indirect manufacturing costs.
Calculating Applied Overhead
To find underapplied overhead, one must first determine the amount of overhead applied to production. This applied overhead is calculated using a predetermined overhead rate. Companies establish this rate at the beginning of an accounting period by dividing the total budgeted overhead costs by the budgeted level of activity. For instance, if a company anticipates $200,000 in overhead and 10,000 direct labor hours, the rate would be $20 per direct labor hour.
Once the predetermined rate is set, it is applied to the actual activity levels achieved during the period. If actual direct labor hours for the period were 9,500, the applied overhead would be $190,000 (9,500 hours multiplied by the $20 rate). This figure represents the estimated overhead cost assigned to goods produced.
Identifying Underapplied Overhead
Identifying underapplied overhead involves directly comparing the actual overhead costs incurred with the overhead applied to production. The actual overhead costs include all indirect manufacturing expenses paid or accrued during the period.
If the actual overhead incurred is greater than the overhead applied to production, the difference represents underapplied overhead. For example, if the actual overhead costs for the period were $195,000, and the applied overhead was $190,000, then the underapplied overhead is $5,000. This $5,000 indicates the extent to which actual indirect costs surpassed the amounts allocated to products.
Accounting for Underapplied Overhead
Once underapplied overhead is identified, companies adjust their financial records at the end of the accounting period. The most common accounting treatment involves charging the underapplied amount to the Cost of Goods Sold (COGS). This adjustment increases the COGS, reflecting that the initial cost of products was understated.
This adjustment is necessary because the initial application of overhead did not fully capture the actual indirect costs of production. The general adjusting entry involves debiting the Cost of Goods Sold account and crediting the Manufacturing Overhead account for the underapplied amount. This ensures that the financial statements accurately reflect the true cost of goods sold for the period.