Over-applied and Underapplied Overhead
Learning objectives of this article:
Definition and Explanation of Over and Underapplied 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.
Suppose that two companies A and B have prepared the following estimated data for the coming year:
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.
You may also be interested in other useful articles from “job order costing system” chapter:
Other Related Accounting Articles:
- Predetermined Overhead Rate and Capacity
- Disposition of Underapplied or Overapplied Overhead Balances
- Application of Manufacturing Overhead Cost in Job Order Costing
- Multiple Predetermined Overhead Rates
- Recording Cost of Goods Manufactured and Sold in Job Order Costing
- Job Order Costing System Exercises and Problems
- Job Order Costing Questions and Answers
- Job Order Costing System
- Job Order Costing in Service Companies
- Job Order Costing – The Flow of Cost
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