4.6 Determine and Dispose of Underapplied or Overapplied Overhead - Principles of Accounting, Volume 2: Managerial Accounting

As you’ve learned, the actual overhead incurred during the year is rarely equal to the amount that was applied to the individual jobs. Thus, at year-end, the manufacturing overhead account often has a balance, indicating overhead was either overapplied or underapplied.

If, at the end of the term, there is a debit balance in manufacturing overhead, the overhead is considered underapplied overhead. A debit balance in manufacturing overhead shows either that not enough overhead was applied to the individual jobs or overhead was underapplied. If, at the end of the term, there is a credit balance in manufacturing overhead, more overhead was applied to jobs than was actually incurred. This shows the actual amount was overapplied overhead.

The actual overhead costs are recorded through a debit to manufacturing overhead. The same account is credited when overhead is applied to the individual jobs in production, as shown:

A T-account for Manufacturing Overhead showing the debit as actual cost and the credit as applied costs.

Since the overhead is first recorded in the manufacturing overhead account, then applied to the individual jobs, traced through finished goods inventory, and eventually transferred to cost of goods sold, the year-end balance is eliminated through an adjusting entry, offsetting the cost of goods sold. If manufacturing overhead has a debit balance, the overhead is underapplied, and the resulting amount in cost of goods sold is understated. The adjusting entry is:

A journal entry lists Cost of Goods Sold with space for a debit entry, and Manufacturing Overhead with space for a credit entry.

If manufacturing overhead has a credit balance, the overhead is overapplied, and the resulting amount in cost of goods sold is overstated. The adjusting entry is:

A journal entry lists Cost of Goods Sold with space for a debit entry, and Manufacturing Overhead with space for a credit entry, and the note “Application of overhead to Cost of Goods Sold”.

Returning to our example, at the end of the year, Dinosaur Vinyl had actual overhead expenses of $256,500 and applied overhead expenses of $250,000, as shown:

A T-account for Manufacturing Overhead showing the debit as actual cost of $256,500 and the credit side as applied costs of $250,000.

Since manufacturing overhead has a debit balance, it is underapplied, as it has not been completely allocated. The adjusting journal entry is:

A journal entry lists Cost of Goods Sold with a debit of 6,500, Manufacturing Overhead with credit of 6,500, and the note “Application of underapplied overhead to Cost of Goods Sold”.

If the overhead was overapplied, and the actual overhead was $248,000 and the applied overhead was $250,000, the entry would be:

A journal entry lists Manufacturing Overhead with a debit of 2,000, Cost of Goods Sold with credit of 2,000, and the note “Application of overapplied overhead to Cost of Goods Sold”.

To adjust for overapplied or underapplied manufacturing overhead, some companies have a more complicated, three-part allocation to work in process, finished goods, and cost of goods sold. This method is typically used in the event of larger variances in their balances or in bigger companies. (You will learn more about this in future cost or advanced managerial accounting courses.)

Your Turn

Kraken Boardsports

A photograph shows a person climbing a snow-covered hill carrying a winch on wheels. A photograph shows a person ski-boarding on a lake.

Figure 4.22 (credit: modification of images provided courtesy of Kraken Boardsports, CC BY 4.0)

Kraken Boardsports manufactures winches for snow and ski boarders to snow ski without a mountain or water ski without a lake (Figure 4.22). End-of-year data show these overhead expenses:

Chart showing the following expenses: Indirect materials $25,000, Indirect labor 31,750, Depreciation of factory equipment 50,000, Factory utility expenses 17,500, Factory supervisor salaries 85,000.

Kraken Boardsports had 6,240 direct labor hours for the year and assigns overhead to the various jobs at the rate of $33.50 per direct labor hour.

How much overhead was overapplied or underapplied during the year? What would be the journal entry to adjust manufacturing overhead?

Solution

The total overhead incurred is the total of:

Chart adding the overhead expenses: Indirect materials $25,000, Indirect labor 31,750, Depreciation of factory equipment 50,000, Factory utility expenses 17,500, Supervisor salaries 85,000 added together equal $209,250 of Actual overhead incurred.

The total overhead applied is $209,040, which is calculated as:

$33.50/direct labor hours × 6,240 direct labor hours.

The balance in manufacturing overhead is a debit balance of $210:

A T-account for Manufacturing Overhead showing a debit for actual costs of 209,250, a credit for applied costs of $209,040 and a balance on the debit side of 210.

The adjusting journal entry is:

A journal entry lists Cost of Goods Sold with a debit of 210 and Manufacturing Overhead with a credit of 210.

Link to Learning

Job order costing and overhead allocation are not new methods of accounting and apply to governmental units as well. See it applied in this 1992 report on Accounting for Shipyard Costs and Nuclear Waste Disposal Plans from the United States General Accounting Office.