4.6 Determine and Dispose of Underapplied or Overapplied Overhead

Manufacturing overhead is a crucial aspect of cost accounting. It involves applying indirect costs to products using predetermined rates. This process helps companies allocate expenses and determine product costs accurately, impacting financial reporting and decision-making.

Variances between applied and actual overhead are common. These differences, whether overapplied or underapplied, affect the Cost of Goods Sold and net income. Understanding how to calculate and dispose of these variances is essential for maintaining accurate financial statements.

Applying Manufacturing Overhead

Calculation of overhead variances

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• Manufacturing overhead applied to products using a predetermined overhead rate
  • Predetermined overhead rate calculated as $\frac{Estimated\ total\ manufacturing\ overhead\ costs}{Estimated\ total\ allocation\ base}$
    • Common allocation bases include direct labor hours, direct labor costs, or machine hours
  • This process is known as overhead absorption
• Actual overhead costs incurred often differ from the amount of overhead applied
  • Overapplied overhead occurs when applied manufacturing overhead exceeds actual manufacturing overhead
  • Underapplied overhead occurs when applied manufacturing overhead is less than actual manufacturing overhead
• Difference between applied and actual overhead calculated at the end of the period
  • Overapplied or underapplied overhead equals applied manufacturing overhead minus actual manufacturing overhead
    • Positive difference indicates overapplied overhead (applied > actual)
    • Negative difference indicates underapplied overhead (applied < actual)
  • This analysis is part of variance analysis in cost accounting

Disposal of overhead variances

• Adjusting entries made to close the manufacturing overhead account and transfer the balance to appropriate accounts
• For overapplied overhead (credit balance in manufacturing overhead account)
  • Debit Manufacturing Overhead account to clear the credit balance
  • Credit Cost of Goods Sold account to reduce COGS and increase net income
• For underapplied overhead (debit balance in manufacturing overhead account)
  • Debit Cost of Goods Sold account to increase COGS and reduce net income
  • Credit Manufacturing Overhead account to clear the debit balance

Impact of variances on COGS

• Overapplied overhead results in an overstatement of COGS during the period
  • Adjusting entry reduces COGS, thereby increasing net income
  • Indicates that the company applied more overhead to products than actually incurred
• Underapplied overhead results in an understatement of COGS during the period
  • Adjusting entry increases COGS, thereby reducing net income
  • Indicates that the company applied less overhead to products than actually incurred
• Impact on COGS affects the company's reported profitability for the period
  • Overapplied overhead leads to higher reported net income
  • Underapplied overhead leads to lower reported net income

Cost Allocation and Overhead Rate Calculation

• Cost allocation involves assigning indirect costs to cost objects
• Overhead rate calculation is crucial for accurate cost allocation
  • Estimated overhead costs divided by estimated allocation base
  • Helps in determining the amount of overhead to be applied to each product or service
• Accurate cost allocation and overhead rate calculation are essential for effective cost accounting practices