What Is Underapplied Overhead?The term underapplied overhead refers to a situation that arises when overhead expenses amount to more than what a company actually budgets for in order to run its operations. Underapplied overhead is normally reported as a prepaid expense on a company's balance sheet and is balanced by inputting a debit to the cost of goods sold (COGS) section by the end of the year. Costs of goods sold are the direct cost associated with the production of goods sold by a company. The amount of underapplied overhead is referred to as an unfavorable variance. Show
Key Takeaways
Understanding Underapplied OverheadBefore looking at how underapplied overhead works, it's important to define overhead costs. The term overhead is used to describe the costs associated with running a business. More specifically, these are expenses that a business incurs for its day-to-day operations but are not directly linked to the creation of a product or service. Overhead is important for businesses for a number of reasons including budgeting and how much to charge their customers in order to realize a profit. Underapplied overhead occurs when a business doesn't budget enough for its overhead costs. This means the budgeted amount is less than the amount the business actually spends on its operations. For example, when a company incurs $150,000 in overhead after budgeting only $100,000, it has an underapplied overhead of $50,000. This is referred to as an unfavorable variance because it means that the budgeted costs were lower than actual costs. Put simply, the business went over budget making the cost of goods sold more than expected. As noted above, underapplied overhead is reported on a company's balance sheet as a prepaid expense or a short-term asset. This debit item on the balance sheet must be offset at a future date. 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. When underapplied overhead appears on financial statements, it is generally not considered a negative event. Rather, analysts and interested managers look for patterns that may point to changes in the business environment or economic cycle. Should unfavorable variance or outcomes arise—because not enough product was produced to absorb all overhead costs incurred—managers will first look for viable reasons. These may be explained by expected hiccups in production, business, or seasonal variation. The initial predetermined overhead cost rate is calculated by taking the budgeted overhead costs divided by the budgeted activity. Special ConsiderationsAnalyzing 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. Advancements in electronic inventory and production management systems have greatly eased the burden of comprehensive operational reporting, often including underapplied overhead analysis. These improvements allow managers to better assess key operational metrics. Underapplied Overhead vs. Overapplied OverheadUnderapplied overhead is the opposite of overapplied overhead. Overapplied overhead occurs when expenses incurred are actually less than what a company accounts for in its budget. This means that a company comes in under budget and achieves a lower amount of overhead costs during the accounting period. Businesses must account for overapplied overheads as well. This is recorded in the opposite manner that underapplied overhead is on the balance sheet—first noted as a credit to the overhead section, which is then offset by a credit on the COGS section and debit on the overhead section by the end of the fiscal year. Definition: Overapplied overhead refers to the amount of money that goes unused despite being assigned to finance the production of units for a given accounting period. Such costs are synonymous with companies with robust manufacturing operations. Such companies allocate overhead expenses at the beginning of each accounting period on an estimated basis. However, at the end of the accounting period, a situation arises whereby the charged
amount is slightly higher than the sum incurred thus leading to overapplied overhead. Companies incur different types of costs as part of the production process. Direct material costs go towards the purchase of raw materials used in the manufacturing process. Direct labor costs, on the other hand, cater to wages paid to workers that enable the production process. Overheads, on the other hand, are costs that cannot be allocated in a satisfactory manner. In this case, companies are
forced to make estimates on some of the costs they are likely to incur. Such costs can include wages paid to employees who aren’t part of the manufacturing process or expenses incurred on the purchase of disposable tools or protective devices. Conversely, the allocation of overhead expenses is done on an estimated basis. Likewise, at the end of an accounting period, it may emerge that the costs charged are slightly lower than what was estimated at the start of the accounting period. Overapplied overhead occurs when there is some amount that is left unspent despite being allocated. Company ABC allocates overheads based on the machine hours used in production. Similarly, at the beginning of a quarter, it estimates that its machines will run for a total of 6,000 hours; consequently, it allocates overhead costs amounting to $60,000, which is $10 per hour. However, at the end of the quarter, it emerges that the machines ran for 7,000 hours resulting in $70,000 worth of costs. The Overapplied overhead cost, in this case, would be $10,000. Causes of Overapplied OverheadIn big manufacturing settings, it is impossible to avoid overapplied overhead, given that there are indirect costs that will always come into play. The fact that such costs cannot be traced to results means they have to be estimated at the start of each accounting period. For that reason, overapplied overhead is the overhead cost that is allocated to a specific department or production unit based on expected overhead costs. Below are some of the reasons why Overapplied overhead come about Labor costsOverhead costs that firms take into account include costs of labor that are not directly used in the production of goods and services. Some of these costs include costs for building a new facility, as it is impossible to pinpoint the exact task that would be completed in future. Facility CostsFacility costs, especially those for financing renovations or renting facilities, also account for a big share of overapplied overhead. Managers must estimate at the beginning of the year the costs they are likely to be charged for the renovation of the production facility or for renting new facilities. Similarly, they may have to allocate funds for fixing a production units or equipment. ResourcesA buyer finding strong deals for goods and materials could lead to a reduction in overhead costs. By making new connections with vendors of raw materials, a business could end up spending much less than initially anticipated leading to overapplied overhead costs. This is especially the case when a business is testing new cost-saving production methods. Increased ProductionPlans to ramp up production can lead to an increase in overhead costs leading to overapplied overhead. For instance, a firm may have to estimate some of the costs needed to facilitate a much bigger production process. SummaryOverapplied overhead in its purest form is the difference between the estimated overhead cost of a given manufacturing process and the manufacturing overhead cost actually incurred. Contents
How do you solve Overapplied or Underapplied overhead?In order to determine whether overhead was over or under applied for the period, the company's cost account balances the manufacturing overhead account. If credits exceed debits, then overhead was over applied, if debits exceed credits than overhead was under applied.
How do you solve applied manufacturing overhead?You can calculate applied manufacturing overhead by multiplying the overhead allocation rate by the number of hours worked or machinery used. So if your allocation rate is $25 and your employee works for three hours on the product, your applied manufacturing overhead for this product would be $75.
How does Overapplied overhead affect cost of goods sold?If overhead is overapplied, more overhead has been applied to inventory than has actually been incurred. Enough overhead must be removed retroactively from Cost of Goods Sold (and perhaps ending inventories) to eliminate this discrepancy. Since Cost of Goods Sold is decreased, overapplied overhead increases net income.
What does it mean to have Overapplied overhead?Overapplied overhead occurs when expenses incurred are actually less than what a company accounts for in its budget. This means that a company comes in under budget and achieves a lower amount of overhead costs during the accounting period. Businesses must account for overapplied overheads as well.
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