Under-applied and Over-applied Overhead

Learning objectives of the article:

1. Define, explain and calculate under-applied and over-applied overhead rate. Give an example.

2. Definition and Explanation of Over and Underapplied Overhead:

   Since the predetermined overhead rate is established before a period begins and is based entirely on estimated data, the overhead cost applied to work in process (WIP) will generally differ from the amount of overhead cost actually incurred during a period. The difference between the overhead cost applied to work in process (WIP) and the actual overhead costs of a period is termed as either underapplied overhead or overapplied overhead. For example if a company calculates its predetermined overhead rate $6 per machine hour. 15,000 machine hours are actually worked and overhead applied to production is therefore $90,000 (15,000 hours × $6). If actual factory overhead is $95,000 then underapplied overhead is $5,000 ($95,000 – $90,000). If the situation is reverse and the company applies $95,000 and actual overhead is $90,000 the overapplied overhead would be $5,000.
   

   Causes / Reasons of underapplied or overapplied overhead:

   The causes / reasons of under or over-applied overhead can be complex. Nevertheless the basic problem is that the method of applying overhead to jobs using a predetermined overhead rate assumes that actual overhead costs will be proportional to the actual amount of the allocation base incurred during the period. If, for example, the predetermined overhead rate is $6 per machine hour, then it is assumed that actual overhead cost incurred will be $6 for every machine hour that is actually worked. There are actually two reasons why this may not be true. First, much of the overhead often consists of fixed costs that do not grow as the number of machine hours incurred increases. Second, spending on overhead items may or may not be under control. If individuals who are responsible for overhead costs do a good job, those costs should be less than were expected at the beginning of the period. If they do a poor job, those costs will be more than expected.
   

   Example:

   Suppose that two companies A and B have prepared the following estimated data for the coming year:
   

   Company               A B Predetermined overhead rate based on Machine-hours Direct materials cost Estimated manufacturing overhead $300,000 $120,000 Estimated machine-hours 75,000 -- Estimated direct materials cost   $80,000 Predetermined overhead rate, (a) ÷ (b) $4 per machine hour 150% of direct materials cost Now assume that because of unexpected changes in overhead spending and changes in demand for the companies' products, the actual overhead cost and the actual activity recorded during the year in each company are as follows:                   Company                A B Actual manufacturing overhead costs $290,000 $130,000 Actual machine-hours 68,000 -- Actual direct materials costs -- $90,000 For each company, note that the actual data for both cost and activity differ from the estimates used in computing the predetermined overhead rate. This results in underapplied overhead and overapplied overhead as follows:                    Company                 A B Actual manufacturing overhead costs $290,000 $130,000 Manufacturing overhead cost applied to work in process during the year: 68,000 actual machine hours × $4 per machine hour 272,000 $90,000 actual direct materials cost × 150% of direct materials cost 135,000 ------------- ------------- Underapplied (overapplied) overhead $ 18,000 $ (5,000) For company A, notice that the amount of overhead cost that has been applied to work in process ($272,000) is less than the actual overhead cost for the year ($290,000). Therefore the overhead is underapplied. Also notice that original estimate of overhead in company A ($300,000) is not directly involved in this computation. Its impact is felt only through the $4 predetermined overhead rate that is used.For B company the amount of overhead cost that has been applied to work in process (WIP) ($135,000) is greater than the actual overhead cost for the year ($130,000), and so overhead is overapplied. A summary of the concepts discussed so for is presented below: At the beginning of the period Estimated total manufacturing overhead cost  ÷ Estimated total units in the allocation base = Predetermined overhead rate During the period Predetermined overhead rate × Actual total units of the allocation base incurred during the period = Total manufacturing overhead applied At the end of the period Actual total manufacturing overhead cost – Total manufacturing overhead applied = Underapplied (overapplied) overhead

   What disposition should be made of any under or over applied overhead balance remaining in the manufacturing overhead account at the end of a period? To understand the procedure of disposing off any under or over applied overhead see disposition of any balance remaining in the manufacturing overhead account at the end of a period page.