Question

What is over-allocated overhead? and What is under-allocated overhead?

Answer 1

• In simple words:

>Over allocated overhead is a term given to allocated overheads when Allocated Overheads are MORE than Actual Overheads.
>Under Allocated Overhead is a term given to allocated overheads when Allocated Overheads are LESS than Actual Overheads.

STUDY IN DETAIL ----

• Where production takes places, there are certain expenses which are directly related to production like Direct Material , Direct Labor. These are called Direct production cost and do not need to be allocated, as it is distinguishable to which product such cost belongs to.
• However, there are certain Indirect Expenses related to production. These are called OVERHEADS (or factory Overheads). These are not incurred for a particular product, rather for the whole factory. Examples can be: factory rent, Factory Maintenance, Indirect material, etc.
• Since Indirect cost or Factory Overheads also NEED TO BE PART of production cost of a product, there arise a need as to how allocate these Overheads to different products.
• For this purpose, the companies, what they do is that they calculated a ‘rate’ (referred to as predetermined allocation rate) based on certain allocation base at the beginning of time, and on the basis of that ‘rate’, overheads gets allocated.
• Lets have an example:

--A company estimates that it will incur $ 500,000 of factory overhead, and wants to allocate it using estimated 125,000 direct labor hours.

--Now the ‘predetermined overhead allocation rate’ will be $ 500,000 / 125,000 = $ 4 per direct labor hour.

--Based on example above: Case of Over – Allocated Overhead:

Let’s assume that actual direct labor hours were 115,000, and actual factory overheads were $ 450,000

A	Estimated Manufacturing Overhead	$          500,000.00
B	Estimated Direct Labor Hours	125,000
C = A/B	Predetermined Overhead rate	$                       4.00
D	Actual direct labor hours	115,000
E = C x D	Amount of Overhead ALLOCATED	$          460,000.00
F	Actual Overhead	$          450,000.00
G = E - F	Difference	$           10,000.00
	Result	OVER ALLOCATED. Because Applied Overheads are MORE than Actual Overhead

--Based on example above: Case of Under – Allocated Overhead:

Let’s assume that actual direct labor hours were 110,000 and actual factory overheads were $ 450,000

A	Estimated Manufacturing Overhead	$          500,000.00
B	Estimated Direct Labor Hours	125,000
C = A/B	Predetermined Overhead rate	$                       4.00
D	Actual direct labor hours	110,000
E = C x D	Amount of Overhead ALLOCATED	$          440,000.00
F	Actual Overhead	$          450,000.00
G = E - F	Difference	$          10,000.00
	Result	UNDER - ALLOCATED. Because Allocated Overheads are LESS than Actual Overhead