Methods To Dispose Of Underapplied Or Overapplied Manufacturing Overhead Are

Methods to Dispose of Underapplied or Overapplied Manufacturing Overhead

Manufacturing overhead represents indirect costs incurred during the production process. Accurately allocating these costs is crucial for determining the true cost of goods manufactured and ultimately, profitability. However, the actual overhead costs often differ from the predetermined overhead rate used for cost allocation, resulting in either underapplied or overapplied overhead. This article will delve into the various methods used to dispose of these variances, explaining their implications and helping you choose the best approach for your specific circumstances.

Understanding Underapplied and Overapplied Overhead

Before exploring disposal methods, let's clarify the terms:

• Underapplied Overhead: This occurs when the actual manufacturing overhead costs exceed the applied overhead costs. In simpler terms, you spent more on overhead than you initially budgeted for. This results in a debit balance in the manufacturing overhead account.

• Overapplied Overhead: This happens when the applied overhead costs exceed the actual manufacturing overhead costs. You spent less on overhead than anticipated. This creates a credit balance in the manufacturing overhead account.

These discrepancies arise due to various factors, including inaccurate estimations of overhead costs, fluctuations in production volume, and unforeseen expenses.

Methods for Disposing of Overhead Variances

Several methods exist for adjusting the underapplied or overapplied overhead. The choice depends on the materiality of the variance and the company's accounting policies. Here are some of the most common:

1. Proration Based on Ending Balances

This method distributes the overhead variance proportionally across the ending balances of Work in Process (WIP), Finished Goods, and Cost of Goods Sold (COGS). The rationale is that the overhead variance affects all three accounts, and therefore, should be allocated accordingly.

Calculation:

The variance is allocated based on the ratio of each account's ending balance to the sum of the ending balances of WIP, Finished Goods, and COGS. For example:

• WIP Ending Balance: $10,000
• Finished Goods Ending Balance: $20,000
• COGS Ending Balance: $70,000
• Total Ending Balances: $100,000
• Overhead Variance (Underapplied): $5,000

Allocation:

• WIP: ($10,000 / $100,000) * $5,000 = $500 (Debit to WIP)
• Finished Goods: ($20,000 / $100,000) * $5,000 = $1,000 (Debit to Finished Goods)
• COGS: ($70,000 / $100,000) * $5,000 = $3,500 (Debit to COGS)

This method is relatively straightforward and ensures the variance is spread across all relevant accounts. However, it can be less accurate if the overhead costs are more closely related to one account than others.

2. Proration Based on Applied Overhead

Similar to the previous method, this approach prorates the variance based on the amount of overhead applied to each account. This method recognizes the proportion of overhead applied to each inventory account and cost of goods sold. It uses the applied overhead in each account as the basis for allocation, instead of the ending balances.

Calculation:

Assume the applied overhead is distributed as follows:

• WIP: $5,000
• Finished Goods: $10,000
• COGS: $35,000
• Total Applied Overhead: $50,000
• Overhead Variance (Underapplied): $5,000

Allocation:

• WIP: ($5,000 / $50,000) * $5,000 = $500 (Debit to WIP)
• Finished Goods: ($10,000 / $50,000) * $5,000 = $1,000 (Debit to Finished Goods)
• COGS: ($35,000 / $50,000) * $5,000 = $3,500 (Debit to COGS)

This method might be preferable when the applied overhead more accurately reflects the actual consumption of overhead resources by each account.

3. Direct Write-Off to Cost of Goods Sold

This is the simplest method. The entire overhead variance is directly written off to the Cost of Goods Sold account. This method is particularly suitable when the variance is immaterial relative to the overall cost of goods sold.

Underapplied Overhead: A debit is added to the Cost of Goods Sold account, increasing the expense.

Overapplied Overhead: A credit is made to the Cost of Goods Sold account, reducing the expense.

While straightforward, this method might distort the true cost of goods sold, especially if the variance is significant.

4. Adjustment to the Overhead Control Account

This approach involves adjusting the manufacturing overhead control account directly. It's generally less preferred because it doesn't reflect the impact of the variance on the cost of goods sold or inventory valuations.

5. Using a More Accurate Predetermined Overhead Rate

The most proactive approach is to prevent significant variances by improving the accuracy of the predetermined overhead rate. This involves:

• More Accurate Cost Estimation: Carefully analyze past data, consider future trends, and involve relevant departments in the budgeting process.
• Activity-Based Costing (ABC): Implement ABC systems to assign overhead costs based on the activities that drive them, resulting in a more precise allocation.
• Regular Monitoring and Adjustments: Continuously monitor actual overhead costs against the budgeted amounts and make adjustments to the predetermined rate as needed throughout the year. This allows for timely corrections, minimizing the final variance at year-end.

This prevents large variances from accumulating and reduces the need for complex disposal methods.

Choosing the Right Method

The optimal method for disposing of overhead variances depends on several factors:

• Materiality of the Variance: For immaterial variances, a direct write-off to Cost of Goods Sold is often acceptable. For significant variances, a more sophisticated method like proration is generally preferred.

• Company Policy: Companies often have established policies regarding overhead variance disposal. Adhering to these policies ensures consistency and comparability of financial statements.

• Desired Level of Accuracy: Proration methods offer a more accurate reflection of the variance's impact on different accounts compared to a direct write-off.

• Industry Practices: Industry-specific standards and best practices may influence the chosen method.

Implications of Choosing the Wrong Method

Using an inappropriate method can lead to several issues:

• Inaccurate Costing: Distorted cost figures can lead to flawed pricing decisions, inefficient resource allocation, and incorrect performance evaluations.

• Misleading Financial Statements: Incorrect treatment of overhead variances can misrepresent the company's profitability and financial position.

• Tax Implications: The method used for disposing of overhead variances can have implications for income tax calculations.

• Auditing Concerns: Incorrectly handled variances may raise concerns during audits.

Conclusion

Effectively managing and disposing of underapplied or overapplied manufacturing overhead is critical for accurate cost accounting and reliable financial reporting. While several methods exist, the choice should be driven by factors such as materiality, company policy, desired accuracy, and industry practices. Proactive measures, such as refining the predetermined overhead rate, are crucial for minimizing variances and simplifying the disposal process. Understanding the implications of each method allows for a more informed decision, leading to improved financial reporting and more efficient management of manufacturing operations. Remember to maintain consistent application of the chosen method year after year for accurate financial reporting and easier analysis of trends. Consulting with an accounting professional is always recommended to ensure compliance and best practices are followed.