Key Takeaways
- Underapplied overhead: actual costs exceed applied overhead.
- Causes include higher expenses or lower production volume.
- Underapplied overhead increases Cost of Goods Sold (COGS).
What is Underapplied Overhead?
Underapplied overhead occurs when the actual manufacturing overhead costs exceed the overhead applied to production using a predetermined rate. This variance is common in job-order costing systems where companies estimate overhead but actual expenses turn out higher, requiring adjustment to reflect true costs. Understanding this concept is essential for accurate cost accounting and financial reporting under GAAP.
Key Characteristics
These are the main features that define underapplied overhead:
- Unfavorable variance: Actual overhead costs are greater than applied overhead, leading to a debit balance in the overhead account.
- Predetermined overhead rate: Calculated using estimated costs and activity levels to allocate overhead during production.
- Indirect costs involved: Includes expenses like utilities, depreciation, and indirect labor that cannot be traced directly to products.
- Adjustment necessity: Requires correction at period-end to align reported costs with actual expenses, often impacting Cost of Goods Sold.
- Accounting treatment: Involves debiting Cost of Goods Sold and crediting Manufacturing Overhead to close the variance.
How It Works
Manufacturing overhead is applied to products during production using a predetermined rate based on estimated overhead and activity, such as machine hours. When actual overhead costs exceed these applied amounts, the difference is recorded as underapplied overhead, indicating that product costs have been understated.
At the end of the accounting period, you must adjust your records by debiting Cost of Goods Sold and crediting the overhead account to reflect the true expenses. This process ensures your financial statements accurately present manufacturing costs and comply with T-account bookkeeping methods.
Examples and Use Cases
Here are practical examples illustrating underapplied overhead scenarios:
- Airlines: Delta may experience underapplied overhead if actual maintenance and operational costs exceed budgeted amounts due to unexpected repairs or fuel price increases.
- Manufacturing firms: A company applying overhead based on estimated machine hours may find actual utility costs higher, resulting in underapplied overhead that requires adjustment in financial records.
- Small businesses: Using efficient expense tracking and understanding overhead variances can improve budgeting; check out our guide on best business credit cards to manage cash flow effectively.
Important Considerations
Underapplied overhead signals that actual indirect costs are higher than anticipated, which can indicate inefficiencies or increased expenses. Monitor these variances closely to identify operational issues and refine your predetermined rates for future accuracy.
Properly adjusting for underapplied overhead is critical to avoid misstated product costs, which could distort profitability analysis and pricing decisions. Maintaining compliance with activity-based costing principles can help you allocate overhead more precisely and reduce variances over time.
Final Words
Underapplied overhead signals that actual manufacturing costs exceeded estimates, impacting your cost of goods sold and profitability. Review your overhead allocation methods and adjust your predetermined rates to better match actual expenses in future periods.
Frequently Asked Questions
Underapplied overhead occurs when the actual manufacturing overhead costs are greater than the overhead applied to production using a predetermined rate, resulting in an unfavorable variance.
Underapplied overhead can happen due to higher-than-expected costs like utility spikes, lower production volumes which spread fixed costs over fewer units, or inefficiencies in operations.
It's calculated by subtracting the applied overhead—based on estimated rates and activity—from the actual overhead costs incurred; if actual costs exceed applied, the difference is underapplied overhead.
Underapplied overhead increases the Cost of Goods Sold (COGS) because the excess actual overhead costs must be added to expenses, reducing reported profit.
At year-end, companies typically close the underapplied overhead to the Cost of Goods Sold account by debiting COGS and crediting Manufacturing Overhead to align expenses with actual costs.
Yes, if overhead is consistently underapplied, it means product costs are underestimated, which can lead to setting prices too low and affecting profitability.
Underapplied overhead means actual overhead costs are higher than applied overhead, while overapplied overhead means applied costs exceed actual expenses, resulting in a favorable variance.
