Underapplied Or Overapplied Overhead Is The

Underapplied or Overapplied Overhead: Understanding the Implications

Overhead costs are a crucial aspect of cost accounting that often cause confusion. Understanding how to accurately account for overhead is vital for businesses to make informed decisions about pricing, profitability, and overall financial health. This article delves into the complexities of underapplied and overapplied overhead, explaining what they are, their causes, and how to handle them effectively.

What is Overhead?

Before we dive into underapplied and overapplied overhead, it's essential to define what overhead represents. Overhead costs, also known as indirect costs, are expenses that aren't directly tied to producing a specific product or service. Instead, they support the overall operations of the business. Examples include:

• Rent: The cost of leasing a factory or office space.
• Utilities: Electricity, water, gas, and other utility bills.
• Salaries of Support Staff: Pay for administrative personnel, supervisors, and maintenance staff.
• Depreciation: The gradual decrease in value of assets over time.
• Insurance: Premiums for property, liability, and other insurance coverage.
• Property Taxes: Taxes levied on business property.

These costs are necessary for the business to function but aren't easily traceable to individual products or services. Therefore, businesses use various methods to allocate overhead costs to different cost objects (e.g., products, departments).

How is Overhead Applied?

The process of allocating overhead costs involves selecting an allocation base. This base is a measure of activity that is directly related to the overhead costs incurred. Common allocation bases include:

• Direct Labor Hours: The total number of hours worked by direct labor employees.
• Machine Hours: The total number of hours machines are used in production.
• Direct Labor Costs: The total wages paid to direct labor employees.
• Units Produced: The total number of units manufactured.

Once an allocation base is chosen, a predetermined overhead rate is calculated. This rate is determined by dividing the estimated total overhead costs for a period by the estimated total activity level for the chosen allocation base.

Formula: Predetermined Overhead Rate = Estimated Total Overhead Costs / Estimated Total Activity Level

For example, if a company estimates total overhead costs of $100,000 and anticipates 10,000 direct labor hours, the predetermined overhead rate would be $10 per direct labor hour. This rate is then applied to actual production during the period.

What is Underapplied Overhead?

Underapplied overhead occurs when the actual overhead costs incurred during a period exceed the overhead costs applied to production using the predetermined overhead rate. This means the company applied less overhead to its products than it actually incurred. In other words, the company underestimated its overhead.

Example:

Let's assume the company from our previous example incurred actual overhead costs of $110,000 during the period and used 9,500 direct labor hours.

• Overhead Applied: 9,500 hours * $10/hour = $95,000
• Overhead Incurred: $110,000
• Underapplied Overhead: $110,000 - $95,000 = $15,000

This $15,000 represents the difference between the actual overhead costs and the overhead applied, indicating underapplication.

What is Overapplied Overhead?

Overapplied overhead is the opposite of underapplied overhead. It happens when the actual overhead costs incurred during a period are less than the overhead costs applied to production using the predetermined overhead rate. This means the company applied more overhead to its products than it actually spent. In other words, the company overestimated its overhead.

Example:

Continuing with the previous example, let's say the company only incurred actual overhead costs of $85,000 during the period while still using 9,500 direct labor hours.

• Overhead Applied: 9,500 hours * $10/hour = $95,000
• Overhead Incurred: $85,000
• Overapplied Overhead: $95,000 - $85,000 = $10,000

This $10,000 signifies the difference between the overhead applied and the actual overhead incurred, showing overapplication.

Causes of Underapplied and Overapplied Overhead

Several factors can contribute to either underapplied or overapplied overhead:

• Inaccurate Estimation: The most common cause is inaccurate estimations of either total overhead costs or the total activity level used in calculating the predetermined overhead rate. Unexpected increases in utility costs, for instance, can lead to underapplication.
• Changes in Production Levels: Significant changes in production volume compared to the estimations used in calculating the predetermined overhead rate can result in either underapplication or overapplication. If production is lower than expected, overhead might be overapplied, and vice versa.
• Inefficiencies: Inefficiencies in operations can lead to higher-than-expected overhead costs, resulting in underapplied overhead. This might be due to production bottlenecks, equipment breakdowns, or poor resource management.
• Unexpected Costs: Unforeseen events, like natural disasters or significant price increases in raw materials, can also affect overhead costs and lead to either underapplication or overapplication.

Dealing with Underapplied and Overapplied Overhead

At the end of an accounting period, the company must adjust for underapplied or overapplied overhead. There are several methods to handle this discrepancy:

• Proration: This method distributes the difference proportionally across the work-in-process (WIP), finished goods, and cost of goods sold (COGS) accounts. This approach ensures a more accurate reflection of the actual cost of goods sold and inventory.

• Adjusting Cost of Goods Sold: This simpler method involves directly adding underapplied overhead or subtracting overapplied overhead from the cost of goods sold. While simpler, it may not be as accurate as proration, especially if a significant portion of the overhead is related to WIP inventory.

Choosing the Right Method: The choice between proration and adjusting cost of goods sold depends on the materiality of the difference and the company's specific accounting policies. For small differences, adjusting COGS might be sufficient. However, for significant differences, a more accurate proration method is generally preferred.

Importance of Accurate Overhead Allocation

Accurate overhead allocation is critical for several reasons:

• Pricing Decisions: Accurate cost information is essential for setting competitive and profitable product or service prices. Misallocated overhead can lead to underpricing or overpricing, impacting profitability.
• Performance Evaluation: Accurate overhead allocation allows for better evaluation of the performance of different departments or production processes. Identifying areas with high overhead costs helps pinpoint areas for improvement and cost reduction.
• Inventory Valuation: Accurate overhead allocation is crucial for proper valuation of inventory, both work-in-process and finished goods. This directly impacts the company's balance sheet and financial statements.
• Profitability Analysis: Understanding the true cost of producing goods or services is vital for analyzing profitability. Incorrect overhead allocation can distort profitability figures, leading to flawed business decisions.

Minimizing Overhead Discrepancies

Several steps can be taken to minimize the risk of significant underapplied or overapplied overhead:

• Refined Estimation Techniques: Employ more sophisticated forecasting methods to better estimate overhead costs and activity levels.
• Regular Monitoring: Regularly monitor actual overhead costs and compare them to the budgeted amounts. This allows for timely adjustments to prevent large discrepancies at the end of the period.
• Improved Cost Control: Implement robust cost control measures to identify and reduce unnecessary overhead expenses.
• Flexible Budgeting: Utilize flexible budgeting techniques that can adjust to changes in production volume or other relevant factors.
• Activity-Based Costing (ABC): Consider implementing Activity-Based Costing (ABC) which provides a more accurate and detailed allocation of overhead costs, based on the activities that drive those costs. This is particularly useful in businesses with diverse products or services.

Conclusion

Understanding and effectively managing overhead costs, including dealing with underapplied and overapplied overhead, is a critical aspect of successful cost accounting. By accurately estimating overhead costs, selecting appropriate allocation bases, and utilizing appropriate methods to adjust for discrepancies, businesses can make informed decisions, improve profitability, and gain a clearer understanding of their overall financial health. Implementing robust cost control measures and continuously monitoring overhead costs are key to minimizing the impact of these variances and ensuring accurate cost information for sound business strategies.