Under-Applied Overhead

Definition

Under-applied overhead refers to a situation where the actual overhead costs incurred by a business exceed the amount of overhead that has been applied to the products or services produced. This occurs when the predetermined overhead rate used to allocate overhead to production is lower than the actual overhead rate.

5 Must Know Facts For Your Next Test

1. Under-applied overhead results in an understatement of the cost of goods sold and an overstatement of net income on the income statement.
2. The difference between the actual overhead costs and the applied overhead is recorded as an under-applied overhead variance account on the balance sheet.
3. Under-applied overhead can be caused by factors such as lower-than-expected production volume, inefficient use of resources, or inaccurate estimation of the predetermined overhead rate.
4. In a job order cost system, under-applied overhead is typically allocated to the cost of goods sold at the end of the accounting period.
5. In a nonmanufacturing environment, such as a service business, under-applied overhead may be allocated to various expense accounts rather than the cost of goods sold.

Review Questions

• Explain how under-applied overhead is calculated and its impact on the financial statements.
  • Under-applied overhead is calculated as the difference between the actual overhead costs incurred and the overhead costs applied to production using the predetermined overhead rate. This difference is recorded as an under-applied overhead variance account on the balance sheet. The under-applied overhead results in an understatement of the cost of goods sold and an overstatement of net income on the income statement, as the full amount of overhead costs has not been allocated to the products or services produced.
• Describe the potential causes of under-applied overhead and how a business can address this issue.
  • Under-applied overhead can be caused by factors such as lower-than-expected production volume, inefficient use of resources, or inaccurate estimation of the predetermined overhead rate. To address under-applied overhead, a business can review and adjust the predetermined overhead rate, improve production efficiency, or explore ways to increase production volume. Additionally, the business can analyze the underlying causes of the under-applied overhead and implement strategies to better align the estimated and actual overhead costs.
• Explain how the treatment of under-applied overhead differs between a manufacturing and a nonmanufacturing environment, and the rationale behind these differences.
  • In a manufacturing environment that uses a job order cost system, under-applied overhead is typically allocated to the cost of goods sold at the end of the accounting period. This is because the overhead costs are directly related to the production of the goods, and the under-applied portion should be included in the cost of the products sold. In a nonmanufacturing environment, such as a service business, under-applied overhead may be allocated to various expense accounts rather than the cost of goods sold. This is because the overhead costs in a nonmanufacturing environment are not directly tied to the production of a specific product, and the under-applied portion is more appropriately recognized as an operating expense.

Related terms

Overhead: Overhead costs are indirect expenses incurred by a business that cannot be directly attributed to the production of a specific product or service, such as rent, utilities, and administrative salaries.

Predetermined Overhead Rate: The predetermined overhead rate is an estimate of the overhead cost per unit of the cost driver, such as direct labor hours or machine hours, used to allocate overhead to production.

Over-Applied Overhead: Over-applied overhead occurs when the actual overhead costs incurred by a business are less than the amount of overhead that has been applied to the products or services produced.