Underapplied Or Overapplied Overhead Is The Blank

2 min read 08-12-2024

Underapplied Or Overapplied Overhead Is The Blank

Overhead costs are indirect costs that aren't directly tied to specific products or services. Examples include rent, utilities, and administrative salaries. These costs need to be allocated to products or services to determine accurate product costing and profitability. When the allocation process doesn't perfectly match actual overhead costs, the result is either underapplied or overapplied overhead.

What is Underapplied Overhead?

Underapplied overhead occurs when the amount of overhead applied to products is less than the actual overhead costs incurred. This means the company didn't allocate enough overhead to cover its actual expenses. The result is that the cost of goods sold (COGS) is understated, and net income is overstated.

In simpler terms: The company spent more on overhead than it planned for and accounted for.

Example of Underapplied Overhead

Imagine a manufacturing company budgeted $100,000 in overhead costs and applied $90,000 to its products based on a predetermined overhead rate. If the actual overhead costs turned out to be $105,000, there's a $15,000 underapplied overhead ($105,000 - $90,000).

What is Overapplied Overhead?

Conversely, overapplied overhead happens when the overhead applied to products is more than the actual overhead costs incurred. This means the company allocated more overhead than it actually spent. Consequently, the cost of goods sold is overstated, and net income is understated.

In simpler terms: The company spent less on overhead than it planned for and accounted for.

Example of Overapplied Overhead

Using the same manufacturing company example, if the actual overhead costs were only $85,000, there's a $5,000 overapplied overhead ($90,000 - $85,000).

How to Account for Underapplied or Overapplied Overhead

At the end of the accounting period, the difference between applied and actual overhead must be adjusted. Common methods include:

Adjusting Cost of Goods Sold: This is the simplest approach. The entire difference is added to or subtracted from the cost of goods sold. If overhead is underapplied, COGS is increased; if it's overapplied, COGS is decreased.
Proration: This method allocates the difference proportionately across the cost of goods sold, work-in-progress (WIP), and finished goods inventory. This is generally considered a more accurate approach as it reflects the impact on multiple accounts.

Significance and Implications

Understanding whether overhead is underapplied or overapplied is crucial for accurate financial reporting. A significant variance indicates potential issues with:

Overhead budgeting: The company's budget might be inaccurate, requiring adjustments.
Overhead allocation: The method used to allocate overhead might need review and improvement.
Production efficiency: Large variances can signal inefficiencies in production processes.

Consistent monitoring and analysis of overhead variances are key to effective cost management and improved profitability. Addressing the reasons behind significant under or over application is essential for maintaining financial accuracy and making informed business decisions.