Question

What is underapplied overhead? Overapplied overhead? What disposition is made of these amounts at the end of the period?

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Answer 1

Actual overhead are the manufacturing costs other than direct materials and direct labor. Since the overhead costs are not directly traceable to products, the overhead costs must be allocated, assigned, or applied to goods produced.

Example overhead costs are:

• Electricity used to power the production equipment
• Natural gas to heat the production facilities
• Depreciation of the production equipment and facilities
• Normal repairs and maintenance of the production equipment
• Salaries and benefits for production supervisors

Applied overhead is the amount of the manufacturing overhead that is assigned to the goods produced. This is usually done by using a predetermined annual overhead rate.

Example :

Let's assume that a company expects to have $500,000 of overhead costs in the upcoming year. It also expects that it will have its normal 10,000 of production machine hours during the upcoming year. As a result, the company will apply, allocate, or assign overhead to the goods manufactured using a predetermined overhead rate of $50 ($500,000 divided by 10,000) for every production machine hour used.

Since the future overhead costs and future number of machine hours were not known with certainty, and since the actual machine hours will not occur uniformly throughout the year, there will always be a difference between the actual overhead costs incurred and the amount of overhead applied to the manufactured goods.

If the amount of overhead assigned to the products manufactured is greater than the amount of overhead actually incurred, the products have overapplied the overhead costs.

If the amount of overhead assigned to the products is less than the amount of overhead actually incurred, the products have underapplied the overhead costs.

The underapplied amount will be charged to (debit) Cost of Goods Sold and overapplied amount will reduce the (credit) Cost of Goods Sold