Question

Overhead application to costs is a critical issue for the costing of your products. We are studying several ways to handle this situation. Describe overhead and the overhead application process. What would cause an overhead to be overapplied, or underapplied. Discuss the results to your decision making and the financial statements for each of those two situations. Describe how the over or under application of overhead should be corrected in the accounting records.

Answer 1

Overheads:

Overheads are cost incurred in the production. They facilitate the production and are not directly associated with production like direct material and direct labor. They are indirect manufacturing expense for example: factory supervisor charges, indirect material, indirect labor, factory depreciation, factory supplies, etc

Overhead application process

Overhead rate is pre-determined at the beginning of the year based on estimated total overheads and estimated total cost driver. The cost driver can be labor hours, machine hours or direct labor cost. This pre-determined overheads rate is applied to the actual cost driver incurred during the year to get applied manufacturing overheads to job or process. The purpose of apply pre-determined overhead is to help in product costing and have a uniformity in overhead application to products.

Over-applied or under-applied overheads

The difference between manufacturing overhead applied to production and actual manufacturing overheads can be over or under application of overheads. If the manufacturing overhead applied is greater than actual overheads it is over-applied overheads. If the actual overheads are greater than applied manufacturing overheads it is under-applied overheads

Impact on decision making and financial statements:

When overheads are Over-applied the cost of goods sold will be higher and   work in process inventory and finished goods inventory will be at higher cost in financial statements

When overheads are under-applied the cost of goods sold will be lower and work in process inventory and finished goods inventory will be at lower cost in financial statements

Correction in accounting records:

The over-applied or under-applied overheads are disposed off at the end of the year. There are 2 approaches to account for the same

· If the over or under applied overheads is insignificant they are disposed off by charging to cost of goods sold

· If the over or under applied overheads are significant they are disposed off by proportionately to Cost of goods sold , Work in process inventory and Finished goods inventory. The proportion of Cost of goods sold, work in process and finished goods inventory is taken as basis for allocation.