Manufacturing overhead encompasses all manufacturing costs that are not attributed back to a specific job. Due to the difficulty of accurately predicting the amount of manufacturing overhead that will be used throughout the year, it is common to incur over- or underapplied manufacturing overhead at the fiscal year end. This amount must be accounted for in order to balance the financial statements. Show
Causes of Underapplied Manufacturing Overhead
Recording Underapplied Manufacturing Overhead
Accounting Treatment of Underapplied Manufacturing Overhead
Effect of Underapplied Manufacturing Overhead
Actual OverheadAs the overhead costs are actually incurred, the Factory Overhead account is debited, and logically offsetting accounts are credited. The table below provides representative examples. The indirect labor would relate to the cost of factory staff not directly involved in production. This can include break time of line workers, shop managers, maintenance, guards, and so forth. The indirect materials relates to supplies and components that are not a significant cost item. Importantly, selling and administrative costs not related to production (e.g., advertising, salaries for non-production related staff, sales commissions, rent of the corporate offices, etc.) are separately expensed, and are not part of factory overhead. A typical entry to record factory overhead costs would be as follows: To recap, the Factory Overhead account is not a typical account. It does not represent an asset, liability, expense, or any other element of financial statements. Instead, it is a “suspense” or “clearing” account. Amounts go into the account and are then transferred out to other accounts. In this case, actual overhead goes in, and applied overhead goes out. The Balance Of Factory OverheadSince the Factory Overhead account is debited for actual overhead incurred and credited for allocated (applied) overhead, the general ledger account would appear as follows (the job costs are newly assumed for this illustration): The next graphic provides a visual representation of the cost flow associated with the Factory Overhead account. In this case, the applied overhead equaled the actual overhead, leaving a zero balance. This means that the predetermined allocation rate was exactly what was incurred during the period. More often than not, this level of perfection will not result. Underapplied OverheadA more likely outcome is that the applied overhead will not equal the actual overhead. The following graphic shows a case where $100,000 of overhead was actually incurred, but only $90,000 was applied. This last situation is called underapplied overhead. It is said to be an “unfavorable” outcome, because not enough jobs were produced to absorb all of the overhead incurred. This might result from below normal levels of output or overspending. In any event, the fact remains that more was spent than allocated. Because the Factory Overhead account is just a clearing account (not a financial statement account), the remaining balance must be transferred out. Several options are available for disposing of this amount, but one approach is to remove (credit) the underapplied amount and charge (debit) Cost of Goods Sold: The preceding entry has the effect of reducing income for the excessive overhead expenditures. Only $90,000 was assigned directly to inventory and the remainder was charged to cost of goods sold. Overapplied OverheadIf the applied overhead exceeds the actual amount incurred, overhead is said to be overapplied. This is usually viewed as a favorable outcome, because less has been spent than anticipated for the level of achieved production. The next journal entry shows the reduction of cost of goods sold to offset the amount of overapplied overhead: Always keep in mind that the goal is to “zero out” the Factory Overhead account and measure the actual cost incurred. In this last example, $100,000 was actually spent and accounted for: $110,000 charged to specific jobs and $10,000 offset as a reduction in cost of goods sold. These illustrations of the disposition of under- and overapplied overhead are typical, but not the only solution. A more theoretically correct approach would be to reduce cost of goods sold, work in process inventory, and finished goods inventory on a pro-rata basis. However, this approach is cumbersome and occasionally runs afoul of specific accounting rules discussed next. Influence Of GAAPAlthough managerial accounting information is generally viewed as for internal use only, be mindful that many manufacturing companies do prepare external financial statements. And, generally accepted accounting principles dictate the form and content of those reports. For example, generally accepted accounting principles require that underapplied overhead relating to idle facilities, wasted material, the allocation of fixed production overhead, and so forth, be charged to current period income by means similar to those just illustrated.
Principlesofaccounting.com ™ Copyright © 2022. All rights reserved. How to determine if the manufacturing overhead is overapplied or underapplied?If manufacturing overhead has a debit balance, the overhead is underapplied, and the resulting amount in cost of goods sold is understated. The adjusting entry is: If manufacturing overhead has a credit balance, the overhead is overapplied, and the resulting amount in cost of goods sold is overstated.
How to calculate over or under allocated manufacturing overhead?Apply the overhead by multiplying the overhead allocation rate by the number of direct labor hours needed to make each product. If product X requires 50 hours, you must allocate $166.5 worth of overhead (50 hours x $3.33) to this product.
Is manufacturing overhead a debit or credit account?The manufacturing overhead account is a holding account for the actual overhead costs incurred (debits) and applied to work-in-process (credits). o Actual overhead costs flow into the account as they are incurred o Applied overhead costs flow out of the account as the jobs proceed through the production process.
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