Disposition of Underapplied or Overapplied Overhead Balances


Disposition of Underapplied or Overapplied Overhead Balances:

Learning objective of the article:

  1. How is over and under applied overhead is disposed off. Give an example to explain the procedure?

What disposition should be made of an underapplied overhead or overapplied overhead balance remaining in the manufacturing overhead account at the end of a period?

Generally any balance in the account is treated in one of the two ways.

  1. Closed out to cost of goods sold.

  2. Allocated between work in process (WIP), finished goods and cost of goods sold in proportion to the overhead applied during the current period in the ending balances of these account.

The second method, which allocates the under or overapplied overhead among ending inventories and cost of goods sold is equivalent to using an “actual” overhead rate and is for that reason considered by many to be more accurate than the first method. Consequently, if the amount of underapplied or overapplied overhead is material, many accountants would insist that the second method be used.

Closed Out to Cost of Goods Sold:

Closing out the balance in manufacturing overhead account to cost of goods sold is simpler than the allocation method.

Where the overhead is underapplied following journal entry is made:

Cost of goods sold
Manufacturing overhead
Dr
Cr

Where the overhead is overapplied the following journal entry is made:

Manufacturing overhead


Cost of goods sold

Dr


Cr

After passing one of these journal entries, cost of goods sold is adjusted. Consequently cost of goods sold is increased by the amount of underapplied and decreased by the amount of overapplied overhead.

Example:

Cost of Goods Manufactured:
Direct materials $50,000
Direct labor $60,000
Manufacturing overhead applied to work in process $90,000*
———
Total Manufacturing cost $200,000
Add: Beginning work in process $30,000
———-
$230,000
Deduct: Ending work in process inventory $72,000
———-
Cost of goods manufactured $158,000
========
Cost of Goods Sold:
Finished goods inventory beginning $10,000
$158,000
———–
Goods available for sale $168,000
Deduct: Finished goods inventory ending $49,500
———-
Unadjusted cost of goods sold $118,500
Add: Under applied overhead $5,000*
———-
Adjusted cost of goods sold $123,500
========
*Overhead applied = $90,000 (15,000 Direct labor hours × $6.00 Predetermined overhead rate)
Actual overhead = $95,000
Under applied overhead = $95,000 – $90,000 = $5,000
Entry to close the $5,000 of under applied  to cost of goods sold would be as follows:

Cost of goods sold————————– 5,000 Dr
Manufacturing overhead————————- 5,000 Cr

Allocated Between Accounts:

Allocation of under or overapplied overhead between work in process (WIP), finished goods and cost of goods sold (COGS) is more accurate than closing the entire balance into cost of goods sold. The reason is that allocation assigns overhead costs to where they would have gone in the first place had it not been for the errors in the estimates going into the predetermined overhead rate.

Example:

Disposition of Over or Under-applied overhead

If the amount of under-applied or over-applied overhead is significant, it should be allocated among the accounts containing applied overhead: Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. A significant amount of “under-applied” or “over-applied” overhead means that the balances in these accounts are quite different from what they would have been if actual overhead costs had been assigned to production.

Allocation restates the account balances to conform more closely to actual historical cost as required for external reporting by generally accepted accounting principles. The above figure uses assumed data for the Cutting and Mounting Department to illustrate the proration of over-applied overhead among the necessary accounts; had the amount been under-applied, the accounts debited and credited in the journal entry would be the reverse of that presented for over-applied overhead. A single overhead account is used in this illustration.

Theoretically, under-applied or over-applied overhead should be allocated based on the amounts of applied overhead contained in each account rather than on total account balances. Use of total account balances could cause distortion because they contain direct material and direct labor costs that are not related to actual or applied overhead. In spite of this potential distortion, use of total balances is more common in practice for two reasons: First, the theoretical method is complex and requires detailed account analysis. Second, overhead tends to lose its identity after leaving Work in Process Inventory, thus making more difficult the determination of the amount of overhead in Finished Goods Inventory and Cost of Goods Sold account balances

You may also be interested in other useful articles from “job order costing system” chapter:

  1. Measuring Direct Materials Cost in Job Order Costing System
  2. Measuring Direct Labor Cost in Job Order Costing System
  3. Application of Manufacturing Overhead
  4. Job Order Costing System – The Flow of Costs
  5. Multiple Predetermined Overhead Rates
  6. Under-applied overhead and over-applied overhead calculation
  7. Disposition of any balance remaining in the manufacturing overhead account at the end of a period
  8. Predetermined Overhead Rate and Capacity
  9. Recording Non-manufacturing Costs
  10. Recording Cost of Goods Manufactured and Sold
  11. Job Order Costing in Services Companies
  12. Use of Information Technology in Job Order Costing
  13. Advantages and Disadvantages of Job Order Costing System
  14. Job Order Costing Discussion Questions and Answers
  15. Job Order Costing Exercises
  16. Case Studies

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