When a company uses standard costing, it derives a standard amount of overhead cost that should be incurred in an accounting period, and applies it to cost objects (usually produced goods). If the actual amount of overhead turns out to be different from the standard amount of overhead, then the overhead is said to be either under absorbed or over absorbed. If overhead is under absorbed, this means that more actual overhead costs were incurred than expected, with the difference being charged to expense as incurred. This usually means that the recognition of expense is accelerated into the current period, so that the amount of profit recognized declines. Show
If overhead is over absorbed, this means that fewer actual overhead costs were incurred than expected, so that more cost is applied to cost objects than were actually incurred. This means that the recognition of expense is reduced in the current period, which increases profits. For example, if the overhead rate is predetermined to be $20 per direct labor hour consumed, but the actual amount should have been $18 per hour, then the $2 difference is considered to be over absorbed overhead. Reasons for Overhead Under Absorption and Over AbsorptionThere can be several reasons for overhead under absorption or over absorption, including the following:
How to Deal with Overhead Under Absorption or Over AbsorptionWhen under or over absorption is encountered, it is normally dealt with in one of two ways. Either the difference (either positive or negative) is charged to the cost of goods sold at once, or the difference (either positive or negative) is applied to the relevant cost objects. The first approach is easier to accomplish, but less precise. Consequently, an immediate write-off is usually limited to smaller variances, while the latter method is used for larger variances. The entire issue of overhead absorption can be reduced by using just-in-time systems to reduce the amount of inventory on hand at the end of an accounting period. By doing so, a case can be made to charge all overhead costs to expense as incurred. The over or under-applied manufacturing overhead is defined as the difference between manufacturing overhead cost applied to work in process and manufacturing overhead cost actually incurred by the entity during the period. If the manufacturing overhead cost applied to work in process is more than the manufacturing overhead cost actually incurred during a period, the difference is known as over-applied manufacturing overhead. If, on the other hand, the manufacturing overhead cost applied to work in process is less than the manufacturing overhead cost actually incurred during a period, the difference is known as under-applied manufacturing overhead.  The occurrence of over or under-applied overhead is normal in manufacturing businesses because overhead is applied to work in process using a predetermined overhead rate. A predetermined overhead rate is computed at the beginning of the period using estimated information and is used to apply manufacturing overhead cost throughout the period. The procedure of computing predetermined overhead rate and its use in applying manufacturing overhead has been described in “measuring and recording manufacturing overhead cost” article. In the rest of this article, we will discuss how over or under-applied overhead cost is handled in a manufacturing environment. Recording actual and applied overhead cost in manufacturing overhead account:Over or under-applied manufacturing overhead is actually the debit or credit balance of an entity’s manufacturing overhead account (also known as factory overhead account). Actual manufacturing overhead costs are debited and applied manufacturing overhead costs are credited to manufacturing overhead account. All actual overhead costs are debited as they are incurred and applied overhead costs are credited as they are applied to work in process. At the end of a period, if manufacturing overhead account shows a debit balance, it means the overhead is under-applied. On the other hand, if it shows a credit balance, it means the overhead is over-applied. For further explanation of the concept, consider the following example of manufacturing overhead account: IN ABOVE EXAMPLE, THE OVERHEAD IS OVER-APPLIED BY $5,000 The debit or credit balance in manufacturing overhead account at the end of a month is carried forward to the next month until the end of a particular period – usually one year. Disposition of over or under-applied manufacturing overhead:At the end of the year, the balance in manufacturing overhead account (over or under-applied manufacturing overhead) is disposed off by either allocating it among work in process, finished goods and cost of goods sold accounts or transferring the entire amount to cost of goods sold account. These two methods have been discussed below: Method 1: Allocation among work in process, finished goods and cost of goods sold account:Under this method, the amount of over or under-applied overhead is disposed off by allocating it among work in process, finished goods and cost of goods sold accounts on the basis of overhead applied in each of the accounts during the period. The following journal entry is made to dispose off an over or under-applied overhead: When overhead is under-applied:When overhead is over-applied:This method is more accurate than the second method. The only disadvantage of this method is that it is more time consuming. Method 2: Transferring the entire amount of over or under-applied to cost of goods sold:Under this method the entire amount of over or under applied overhead is transferred to cost of goods sold. The following entry is made for this purpose: When overhead is under-applied:When overhead is over-applied:This method is not as accurate as first method. Companies use this method because it is less time consuming and easy to use. Example:During the year 2012, Beta company started two jobs – job A and job B . Job A consisted of 1,000 units and job B consisted of 500 units. At the end of the year 2012, job A was completed but job B was in process. The information about manufacturing overhead cost applied to job A and B was as follows: The actual manufacturing overhead cost incurred by the company during 2012 was $108,000. Out of 1,000 units in job A, 750 units had been sold before the end of 2012. Required: Calculate over or under applied manufacturing overhead and make journal entries required to dispose off over or under applied manufacturing overhead assuming:
Solution:Calculation of over or under-applied manufacturing overhead:In our example, manufacturing overhead is under-applied because actual overhead is more than applied overhead. The under-applied overhead has been calculated below: Under-applied manufacturing overhead = Total manufacturing overhead cost actually incurred – Total manufacturing overhead applied to work in process Journal entries to dispose off under-applied overhead:(1). Allocation of under-applied overhead among work in process, finished goods, and cost of goods sold accounts: How are over or under applied overhead treated?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: If manufacturing overhead has a credit balance, the overhead is overapplied, and the resulting amount in cost of goods sold is overstated.
What are the two ways that an under or Overapplied factory overhead balance can be disposed of at the end of a fiscal period?Generally any balance in the account is treated in one of the two ways. Closed out to cost of goods sold. Allocated between work in process (WIP), finished goods and cost of goods sold in proportion to the overhead applied during the current period in the ending balances of these account.
How the firm can dispose of under or overallocated overhead costs?One way to dispose of underallocated or overallocated overhead costs at the end of a fiscal year would be to prorate the underallocated or overallocated overhead costs to the work-in- process control account, the finished goods control account, and to the cost of goods sold account based on the relative amounts in each ...
How are overhead costs treated in cost accounting?Any items of overheads arising out of abnormal situation in business activity should not be treated as overheads. They are charged to Costing Profit and Loss Account. Items not related to business activities such as donation, loss / profit on sale of assets etc are also not to be treated as overheads.
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