What Is Underapplied Overhead?
Underapplied overhead occurs in cost accounting when the amount of overhead costs applied to products or services using a predetermined overhead rate is less than the actual overhead costs incurred during an accounting period. This situation indicates that a company has allocated insufficient indirect costs to its production. Underapplied overhead is a common occurrence in managerial accounting systems, often arising from discrepancies between estimated and actual costs or activity levels.
History and Origin
The concept of allocating indirect costs, including overhead, developed significantly with the rise of industrialization and mass production in the 19th and 20th centuries. As manufacturing processes became more complex, direct costs (like materials and labor) became easier to track than the myriad of indirect factory expenses. Early cost accounting systems emerged to help businesses assign these indirect expenses to products for accurate valuation and pricing. The formalization of cost and management accounting, including methods for handling overhead, is largely attributed to the Industrial Revolution, when the emergence of large business enterprises necessitated more detailed accounting practices. European Journal of Humanities and Social Sciences
Key Takeaways
- Underapplied overhead means that the applied overhead for a period is less than the actual overhead incurred.
- It typically results from underestimating actual overhead costs or overestimating the activity level used for allocation.
- Underapplied overhead increases the cost of goods sold and decreases net income.
- Companies must adjust their accounting records to account for the difference.
- Analyzing underapplied overhead helps management understand deviations from budgeting and improve future cost estimations.
Formula and Calculation
Underapplied overhead is calculated as the difference between actual overhead incurred and overhead applied:
Where:
- Actual Overhead Costs: The total indirect manufacturing expenses incurred during a period (e.g., factory rent, utilities, indirect labor, indirect materials, depreciation on factory equipment).
- Applied Overhead Costs: The amount of overhead allocated to products using a predetermined overhead rate. This is calculated by multiplying the predetermined overhead rate by the actual activity level (e.g., actual direct labor hours, machine hours, or units produced).
For example, if actual overhead was $100,000 and applied overhead was $95,000, then underapplied overhead is $5,000.
Interpreting Underapplied Overhead
Underapplied overhead indicates that a company did not allocate enough indirect production costs to its products or services during a given period. This can happen for several reasons:
- Higher-than-expected actual overhead: Realized overhead costs were greater than what was estimated when the predetermined rate was set. This could be due to unexpected increases in utility rates, maintenance expenses, or indirect labor costs.
- Lower-than-expected actual activity: The actual level of activity (e.g., direct labor hours, machine hours, or units produced) was less than what was estimated. When fewer activity units are produced, less overhead is applied, even if the actual per-unit cost aligns with expectations.
- Inaccurate predetermined overhead rate: The rate itself might have been inaccurately calculated or based on outdated assumptions.
Identifying the specific cause of underapplied overhead is crucial for management to take corrective actions and refine future budgeting and costing processes. It signals that the current costing system might be distorting product costs.
Hypothetical Example
Consider "Alpha Manufacturing," a company that produces custom furniture. Alpha uses direct labor hours to apply overhead to its jobs. At the beginning of the year, Alpha estimated its total annual overhead costs to be $200,000 and its total direct labor hours to be 10,000.
This leads to a predetermined overhead rate of:
During the year, Alpha Manufacturing completes several job costing projects, accumulating 9,500 actual direct labor hours. Based on this, the applied overhead for the year is:
However, at the end of the year, Alpha's actual overhead costs total $198,000.
To find the underapplied overhead:
Alpha Manufacturing has $8,000 in underapplied overhead for the year, meaning it did not apply enough indirect costs to its furniture production.
Practical Applications
Underapplied overhead has direct implications for a company's financial reporting and internal decision-making. According to generally accepted accounting principles (GAAP), manufacturing overhead must be included in the cost of inventory and cost of goods sold. AccountingCoach
The most common method for dealing with underapplied overhead at the end of an accounting period is to adjust the cost of goods sold. When overhead is underapplied, it means that too little cost was initially assigned to the products sold, thereby understating the cost of goods sold and overstating gross profit and net income. To correct this, the underapplied amount is typically added to the cost of goods sold. For example, if a company has $5,000 in underapplied overhead, its journal entry would typically debit Cost of Goods Sold for $5,000 and credit the Manufacturing Overhead Control account for $5,000. This adjustment ensures that the financial statements accurately reflect the true cost of operations and adherence to cost accounting principles, which necessitate that all production-related costs, including indirect ones, are properly accounted for in the valuation of products. Investopedia
Limitations and Criticisms
While necessary for product costing, the process leading to underapplied overhead highlights inherent challenges in traditional overhead allocation. A major limitation is the reliance on a predetermined overhead rate, which is an estimate. If the initial estimates for total overhead costs or the activity base are inaccurate, variances like underapplied overhead are inevitable.
Critics argue that using a single, volume-based cost driver (such as direct labor hours or machine hours) to allocate all overhead costs can lead to distorted product costs. This is particularly true in modern manufacturing environments where indirect costs, especially fixed costs related to technology and automation, are a significant portion of total costs, and direct labor is a shrinking base. Such distortions can cause management to make suboptimal decisions regarding pricing, product mix, or outsourcing. The traditional method may not adequately capture the diversity and complexity of activities that truly drive overhead costs. UiTM Institutional Repository
Furthermore, persistent underapplied overhead could indicate systemic issues with a company's budgeting process or a fundamental misunderstanding of its cost structure. It may signal a need for more sophisticated cost allocation methods, such as activity-based costing (ABC), which aims to assign overhead based on the actual consumption of activities rather than a single, often arbitrary, volume metric.
Underapplied Overhead vs. Overapplied Overhead
The terms "underapplied overhead" and "overapplied overhead" represent opposite outcomes in the overhead allocation process. Both are types of variance analysis and occur when the applied overhead differs from the actual overhead.
| Feature | Underapplied Overhead | Overapplied Overhead |
|---|---|---|
| Definition | Applied overhead < Actual overhead | Applied overhead > Actual overhead |
| Cause | Underestimation of actual overhead or overestimation of activity base. | Overestimation of actual overhead or underestimation of activity base. |
| Impact on COGS | Increases cost of goods sold (debit) | Decreases cost of goods sold (credit) |
| Impact on Income | Decreases net income | Increases net income |
| Indication | Not enough overhead was charged to products. | Too much overhead was charged to products. |
Both situations require an adjustment at the end of the accounting period, typically to the cost of goods sold, to ensure that financial statements accurately reflect the true production costs.
FAQs
What causes underapplied overhead?
Underapplied overhead is primarily caused by two factors: actual overhead costs being higher than budgeted, or the actual activity level (e.g., machine hours, labor hours) being lower than estimated, leading to less overhead being applied than incurred. It can also stem from an inaccurately set predetermined overhead rate.
How is underapplied overhead handled in financial statements?
The most common way to handle underapplied overhead is to add the variance directly to the cost of goods sold on the income statement. This adjustment increases the cost of goods sold and, consequently, reduces the reported net income. For significant amounts, it may be prorated among Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold.
Why is it important to address underapplied overhead?
Addressing underapplied overhead is critical for accurate financial reporting and effective managerial decision-making. Failure to adjust for it results in understated product costs, which can lead to inappropriate pricing decisions, skewed profitability analyses for products, and an overstatement of current period profits. Proper adjustment ensures that all production costs are reflected in the financial statements.
Can underapplied overhead indicate a problem with a company's operations?
Yes, consistently underapplied overhead could indicate issues such as poor budgeting practices, unexpected increases in fixed costs or variable costs, or lower-than-anticipated production volumes. It prompts management to investigate the causes and make necessary operational or planning adjustments.