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.

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:

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.

You may also be interested in other relevant articles:

1. Measuring Direct Materials Cost in Job Order Costing System
2. Measuring Direct Labor Cost in Job Order Costing System
3. Application of Manufacturing Overhead
4. Job Order Costing System--The Flow of Costs
5. Multiple Predetermined Overhead Rates
6. Under-applied overhead and over-applied overhead calculation.
7. Disposition of any balance remaining in the manufacturing overhead account at the end of a period
8. Predetermined Overhead Rate and Capacity
9. Recording Non-manufacturing Costs
10. Recording Cost of Goods Manufactured and Sold
11. Job Order Costing in Services Companies
12. Use of Information Technology in Job Order Costing
13. Advantages and Disadvantages of Job Order Costing System
14. Job Order Costing Discussion Questions and Answers
15. Job Order Costing Exercises
16. Case Studies

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