Learning objective of the article:
- How is over and under applied overhead is disposed off. Give an example to explain the procedure?What disposition should be made of an underapplied overhead or overapplied overhead balance remaining in the manufacturing overhead account at the end of a 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.
The second method, which allocates the under or overapplied overhead among ending inventories and cost of goods sold is equivalent to using an "actual" overhead rate and is for that reason considered by many to be more accurate than the first method. Consequently, if the amount of underapplied or overapplied overhead is material, many accountants would insist that the second method be used.
Closing out the balance in manufacturing overhead account to cost of goods sold is simpler than the allocation method.
Where the overhead is underapplied following journal entry is made:
|Cost of goods sold|| |
Where the overhead is overapplied the following journal entry is made:
|Manufacturing overhead|| |
Cost of goods sold
After passing one of these journal entries, cost of goods sold is adjusted. Consequently cost of goods sold is increased by the amount of underapplied and decreased by the amount of overapplied overhead.
|Cost of Goods Manufactured:|
|Manufacturing overhead applied to work in process||$90,000*|
|Total Manufacturing cost||$200,000|
|Add: Beginning work in process||$30,000|
|Deduct: Ending work in process inventory||$72,000|
|Cost of goods manufactured||$158,000|
|Cost of Goods Sold:|
|Finished goods inventory beginning||$10,000|
|Goods available for sale||$168,000|
|Deduct: Finished goods inventory ending||$49,500|
|Unadjusted cost of goods sold||$118,500|
|Add: Under applied overhead||$5,000*|
|Adjusted cost of goods sold||$123,500|
| *Overhead applied = $90,000 (15,000 Direct labor hours × $6.00 Predetermined overhead rate) |
Actual overhead = $95,000
Under applied overhead = $95,000 - $90,000 = $5,000 Entry to close the $5,000 of under applied to cost of goods sold would be as follows:
Cost of goods sold-------------------------- 5,000 Dr
Manufacturing overhead------------------------- 5,000 Cr
Allocation of under or overapplied overhead between work in process (WIP), finished goods and cost of goods sold (COGS) is more accurate than closing the entire balance into cost of goods sold. The reason is that allocation assigns overhead costs to where they would have gone in the first place had it not been for the errors in the estimates going into the predetermined overhead rate.
Allocation restates the account balances to conform more closely to actual historical cost as required for external reporting by generally accepted accounting principles. The above figure uses assumed data for the Cutting and Mounting Department to illustrate the proration of over-applied overhead among the necessary accounts; had the amount been under-applied, the accounts debited and credited in the journal entry would be the reverse of that presented for over-applied overhead. A single overhead account is used in this illustration.
Theoretically, under-applied or over-applied overhead should be allocated based on the amounts of applied overhead contained in each account rather than on total account balances. Use of total account balances could cause distortion because they contain direct material and direct labor costs that are not related to actual or applied overhead. In spite of this potential distortion, use of total balances is more common in practice for two reasons: First, the theoretical method is complex and requires detailed account analysis. Second, overhead tends to lose its identity after leaving Work in Process Inventory, thus making more difficult the determination of the amount of overhead in Finished Goods Inventory and Cost of Goods Sold account balances