Question

Conceptually, some argue that under‐ or overapplied overhead at the end of the year should be allocated among ending work in process, finished goods, and cost of goods sold. If the over or underapplied overhead is material, explain why this allocation approach would be preferable.

I have this question and I really don't understand it.. can anyone explain to me?

Answer 1

The bottom line is that any under/ overapplied overhead for a given period should be closed by transfer to the different components of inventory at the end of the period.

If all the inventory is sold during the period, it makes perfect sense to allocate the whole amount of under-overapplied overhead to cost of goods sold.

If however, part of the inventory is still there is the form of work in process and/or finished goods, it is more logical to allocate the underapplied or overapplied overhead on a proportionate basis. If the entire amount is adjusted against the cost of goods sold, the cost accounts would fail to reflect the true cost of work in process / finished goods or cost of goods sold. It can lead to distortion of operating income for a period.

For example, if overhead for the period is underapplied by $ 1,000, and the entire amount is allocated to cost of goods sold ( with a debit to cost of goods sold ) , the gross profit for the period would be understated, while the work in process inventory, and the finished goods inventory would be overstated. This would lead to distortion of cost information.

Poor cost information can result in errors in decision making.