What Is Underapplied Overhead in Accounting?

Overhead costs represent a significant portion of a business’s total expenses, yet they are not directly tied to production. Companies must account for these indirect costs to accurately determine the true expense of creating their goods and services. Since actual overhead costs are not known until the end of an accounting period, businesses typically estimate these expenses and apply them to products throughout the year. This article focuses on “underapplied overhead,” which occurs when these initial estimates are inaccurate.

Understanding Overhead Costs

Overhead costs are indirect business expenses not directly tied to producing a specific product or service. Unlike direct costs, such as raw materials or direct labor, overhead supports the overall production process. They cannot be easily traced to a specific unit of output.

Overhead cost examples include factory rent, utility bills, and depreciation on manufacturing equipment. Salaries for factory supervisors, maintenance staff, and quality control personnel are also indirect labor costs. Businesses need to include these costs in their product pricing and financial reporting to ensure that the selling price covers all expenses and generates a profit.

Applying Overhead to Products

Companies apply overhead costs to the products they manufacture or the services they provide. This application is necessary because actual overhead expenses are often only known at the end of an accounting period. To determine a product’s cost for inventory valuation and pricing decisions, businesses rely on a predetermined overhead rate. This rate is calculated by dividing the estimated total overhead costs for a period by an estimated activity base, such as anticipated machine hours or direct labor hours.

For instance, a manufacturing company might estimate its total annual factory overhead to be $500,000 and its total machine hours to be 100,000. This would result in a predetermined overhead rate of $5 per machine hour. As products move through production, $5 of overhead would be applied for every machine hour utilized in their creation. This applied overhead is then added to the direct material and direct labor costs to determine the total estimated cost of each product.

Using estimated rates allows companies to obtain timely product cost information, important for pricing and inventory management decisions. Without a predetermined rate, product costs could not be calculated until all actual overhead expenses were known, making timely operational decisions impossible. This estimation process inherently introduces the possibility of a difference between the estimated and actual overhead.

What Underapplied Overhead Means

Underapplied overhead occurs when actual overhead costs incurred by a business during an accounting period exceed the overhead costs applied to products or services during that period. This arises when initial estimates were too low. It also happens if the actual production activity, such as machine hours or labor hours, was lower than anticipated, meaning less overhead was applied. An unexpected increase in actual overhead costs, like a sudden rise in utility prices or higher-than-expected maintenance expenses, can also lead to underapplied overhead.

For example, if a company estimated $500,000 in overhead but actually incurred $550,000, and only $480,000 was applied to products, it would have $70,000 of underapplied overhead. This discrepancy indicates that the products manufactured during the period have been “undercosted.” Not enough indirect costs were assigned to them, making their reported cost lower than their true economic cost.

This estimation error can have implications for financial reporting and decision-making. Undercosted products could lead to a company setting selling prices that are too low, leading to lower profit margins. It also means that the inventory values on the balance sheet might be understated because they do not fully reflect the total cost of production. Recognizing and correcting underapplied overhead is therefore important for accurate financial statements and informed business strategies.

Accounting for Underapplied Overhead

Companies address underapplied overhead at period end to ensure financial statements accurately reflect actual costs. The method chosen depends on the materiality of the underapplied amount. If the underapplied overhead is immaterial—meaning it is small enough not to significantly mislead financial statement users—the simplest approach is to adjust the Cost of Goods Sold (COGS).

Under this method, the entire underapplied amount is added directly to the Cost of Goods Sold. This increases COGS, which in turn decreases the company’s reported gross profit and net income for the period. For instance, if $10,000 of overhead was underapplied and deemed immaterial, a company would increase its COGS by $10,000 through a journal entry. This adjustment reclassifies the unapplied overhead as an expense, reflecting that more costs were incurred than initially allocated to products.

If the underapplied overhead amount is material, a more complex method known as proration may be used. Proration involves allocating the underapplied amount proportionally among the Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. This method ensures that all accounts affected by the overhead application error bear a fair share of the discrepancy. It is more involved as it requires calculating the proportion of applied overhead remaining in each of these accounts.

Underapplied Versus Overapplied Overhead

While underapplied overhead signifies that actual costs exceeded applied costs, “overapplied overhead” represents the opposite scenario. Overapplied overhead occurs when the actual overhead costs incurred are less than the overhead costs applied to products during a period. This situation also arises from estimation errors, but it results in products being “overcosted” because too much indirect cost was assigned to them.

Both underapplied and overapplied overhead highlight a discrepancy between a company’s estimated and actual indirect costs. Each requires an adjustment at the end of the accounting period to correct the financial records. The direction of the adjustment differs; underapplied overhead increases Cost of Goods Sold or is prorated to increase inventory and COGS, while overapplied overhead decreases these accounts.