Overapplied and underapplied overhead
In a manufacturing setting, overhead costs are applied to production using a predetermined overhead rate. Since this rate is based on estimates, the actual overhead incurred will almost always differ from the overhead applied, resulting in either overapplied or underapplied overhead. Understanding and accounting for these differences is critical for accurate cost reporting and financial statement preparation.
The following are the journal entries throughout the production process that ultimately leads to the over/under application of overhead costs:
Determining overapplied or underapplied overhead
At the end of the accounting period, the organization must reconcile the applied overhead (estimated using a predetermined rate) with the actual overhead incurred during production. This comparison determines whether overhead has been overapplied or underapplied.
Applied overhead equals the predetermined rate times actual activity, so it differs from actual overhead when spending differs from budget or when actual activity differs from the rate’s denominator level - the main source of the gap for fixed overhead. A balance that recurs in the same direction signals the rate should be revised.
This reconciliation is directly related to the two key journal entries presented in the previous table:
- Actual overhead costs are accumulated in the manufacturing overhead control account (e.g., for utilities, depreciation, indirect materials).
- Applied overhead is recorded in the manufacturing overhead applied account as overhead is assigned to production using the predetermined rate.
Ideally, these two accounts should net to zero, meaning all actual costs were accurately allocated to production. However, differences almost always arise:
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Overapplied overhead: applied overhead exceeds actual overhead (), so the amount overapplied equals applied minus actual overhead. This means more overhead was assigned to jobs than was actually incurred, resulting in a credit balance. Unadjusted, inventory and COGS are overstated and operating income is understated.
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Underapplied overhead: applied overhead is less than actual overhead (), so the amount underapplied equals actual minus applied overhead. This means less overhead was assigned to jobs than was actually incurred, resulting in a debit balance. Unadjusted, inventory and COGS are understated and operating income is overstated.
The treatment of this difference depends on its materiality:
The difference is not material The difference is typically closed directly to the cost of goods sold account. Using the below journal entries:
The difference is material The difference should be allocated proportionally across work-in-process (WIP), finished goods (FG), and COGS. The preferred basis is the applied overhead included in each account’s ending balance; an alternative is each account’s total ending balance.
Example: Prorating underapplied overhead
Actual overhead for the period is $620,000 and applied overhead is $600,000, so overhead is underapplied by $20,000. Applied overhead included in the ending balances of WIP, FG, and COGS is $60,000, $90,000, and $450,000, respectively - a total of $600,000.
- WIP’s share:
- FG’s share:
- COGS’s share:
Answer: Debit MOH applied $600,000, debit WIP $2,000, debit FG $3,000, and debit COGS $15,000; credit MOH control $620,000. This closes both accounts and clears the $20,000 underapplied balance. (With a single manufacturing overhead account, the entry is the three debits and a $20,000 credit to manufacturing overhead.)
Activity-based overhead allocation
While traditional overhead allocation methods (e.g., corporate-wide or departmental rates) apply overhead using a single or limited number of allocation bases, activity-based costing (ABC) offers a more refined and accurate approach. In ABC, overhead costs are traced to activities, then assigned to products or services based on their actual consumption of those activities.
Since a comprehensive discussion of ABC is already provided in the activity-based costing section of this textbook, you are encouraged to refer to that section for the following topics:
- The rationale and strategic value of ABC
- Key elements: cost pool, cost driver, resource driver, activity driver, and value-added activity
- Calculation of overhead using ABC
- Comparison of ABC to traditional overhead systems
- Practical applications and limitations
In summary, ABC is especially useful when overhead costs are high and diverse, and when multiple products or services consume activities at different rates. It supports better decision-making in pricing, product design, and cost control.