Under-applied and Over-applied Overhead
Learning objectives of
this article:
- Define, explain and
calculate under-applied and over-applied overhead rate. Give an example.
Definition and Explanation of Over and Under-applied Overhead:
Since the
predetermined overhead rate is established before a period
begins and is based entirely on estimated data, the overhead cost applied to
work in process (WIP) will generally differ from the amount of overhead cost
actually incurred during a period. The difference between the overhead
cost applied to
work in process (WIP) and the actual overhead costs of a period is
termed as either
underapplied overhead or
overapplied overhead. For example if a company calculates its
predetermined overhead rate $6 per machine hour. 15,000 machine hours are
actually worked and overhead applied to production is therefore $90,000
(15,000 hours × $6). If actual factory overhead is $95,000 then
underapplied overhead is $5,000 ($95,000 –
$90,000). If the situation is reverse and the company applies $95,000 and
actual overhead is $90,000 the
overapplied overhead would be $5,000.
Causes / Reasons of under applied or over applied overhead:
The causes / reasons of under or over-applied
overhead can be complex. Nevertheless the basic
problem is that the method of applying overhead to jobs using a
predetermined overhead rate assumes that actual overhead costs will be
proportional to the actual amount of the
allocation base incurred during the period. If, for example, the
predetermined overhead rate is $6 per machine hour, then it is assumed that
actual overhead cost incurred will be $6 for every machine hour that is
actually worked. There are actually two reasons why this may not be true.
First, much of the overhead often consists of
fixed costs that do not grow
as the number of machine hours incurred increases. Second, spending on
overhead items may or may not be under control. If individuals who are
responsible for overhead costs do a good job, those costs should be less
than were expected at the beginning of the period. If they do a poor job,
those costs will be more than expected.
Example:
Suppose that two companies A and B have
prepared the following estimated data for the coming year:
| |
Company
|
| |
A |
B |
|
Predetermined overhead rate based on |
Machine-hours |
Direct materials cost |
|
Estimated
manufacturing overhead |
$300,000 |
$120,000 |
|
Estimated
machine-hours |
75,000 |
-- |
|
Estimated
direct materials cost |
|
$80,000 |
|
Predetermined overhead rate, (a) ÷ (b) |
$4 per machine hour |
150% of direct materials cost |
Now assume that because of unexpected
changes in overhead spending and changes in demand for the
companies' products, the actual overhead cost and the
actual activity recorded during the year in each company are as
follows:
|
| |
Company
|
| |
A |
B |
|
Actual
manufacturing overhead costs |
$290,000 |
$130,000 |
|
Actual
machine-hours |
68,000 |
-- |
|
Actual
direct materials costs |
-- |
$90,000 |
For each company, note that the actual
data for both cost and activity differ from the estimates used in
computing the
predetermined overhead rate. This results in
underapplied overhead and overapplied overhead as follows:
|
|
Company
|
|
A |
B |
|
Actual
manufacturing overhead costs |
$290,000 |
$130,000 |
|
Manufacturing overhead cost applied to work in process during the
year: |
|
|
|
68,000 actual
machine hours ×
$4 per machine hour |
272,000 |
|
|
$90,000
actual direct materials cost ×
150% of direct materials cost |
|
135,000 |
|
------------- |
------------- |
|
Under-applied
(over-applied) overhead |
$ 18,000 |
$ (5,000) |
For company A, notice that the amount of overhead cost that has been
applied to work in process ($272,000) is less than the actual
overhead cost for the year ($290,000). Therefore the overhead is
under-applied. Also notice that original estimate of overhead in
company A ($300,000) is not directly involved in this computation. Its
impact is felt only through the $4
predetermined overhead rate that
is used.For B company the
amount of overhead cost that has been applied to
work in process (WIP)
($135,000) is greater than the actual overhead cost for the year
($130,000), and so overhead is over-applied. A summary of the concepts
discussed so for is presented below:
|
At the beginning of the period |
|
Estimated total
manufacturing overhead cost |
÷ |
Estimated total
units in the allocation base |
= |
Predetermined
overhead rate |
|
During the period |
|
Predetermined
overhead rate |
× |
Actual total units
of the allocation base incurred during the period |
= |
Total manufacturing
overhead applied |
|
At the end
of the period |
|
Actual total
manufacturing overhead
cost |
– |
Total manufacturing
overhead
applied |
= |
Under-applied
(over-applied)
overhead |
|
What disposition should be made of any under
or over applied overhead balance remaining in the manufacturing overhead account
at the end of a period? To understand the procedure of disposing off any
under or over applied overhead see
disposition
of any balance remaining in the manufacturing overhead account at the end of a
period page.
|
