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20.6 Determine and Dispose of Underapplied or Overapplied Overhead

Overhead Application Issues​

Because we use a predetermined overhead rate (based on estimates), the overhead applied to jobs during the period will rarely equal the actual overhead incurred. This difference must be handled at period end.

Underapplied Overhead​

Underapplied overhead occurs when actual overhead exceeds applied overhead.

Causes:

  • Actual overhead higher than estimated
  • Actual activity lower than estimated
  • Inefficient overhead spending
  • Unexpected costs

Example:

  • Actual overhead: €62,000
  • Applied overhead: €60,000
  • Underapplied: €2,000

Overapplied Overhead​

Overapplied overhead occurs when applied overhead exceeds actual overhead.

Causes:

  • Actual overhead lower than estimated
  • Actual activity higher than estimated
  • Efficient overhead spending
  • Better cost control

Example:

  • Actual overhead: €58,000
  • Applied overhead: €60,000
  • Overapplied: €2,000

Disposing of Underapplied/Overapplied Overhead​

There are two main methods for disposing of the difference:

Method 1: Close to Cost of Goods Sold (Simplest)​

If Underapplied:

Cost of Goods Sold             €2,000
    Manufacturing Overhead                    €2,000
To close underapplied overhead

If Overapplied:

Manufacturing Overhead         €2,000
    Cost of Goods Sold                        €2,000
To close overapplied overhead

When to Use:

  • Small difference (immaterial)
  • Most jobs are sold
  • Simple and quick

Method 2: Allocate to Work in Process, Finished Goods, and Cost of Goods Sold (More Accurate)​

If Underapplied: Allocate based on ending balances in accounts.

Example:

  • Underapplied overhead: €2,000
  • Ending balances:
    • Work in Process: €5,000 (25%)
    • Finished Goods: €8,000 (40%)
    • Cost of Goods Sold: €7,000 (35%)
    • Total: €20,000

Allocation:

  • Work in Process: €2,000 × 25% = €500
  • Finished Goods: €2,000 × 40% = €800
  • Cost of Goods Sold: €2,000 × 35% = €700

Journal Entry:

Work in Process                  €500
Finished Goods                    800
Cost of Goods Sold                700
    Manufacturing Overhead                    €2,000
To allocate underapplied overhead

When to Use:

  • Large difference (material)
  • Significant inventory balances
  • More accurate cost allocation

Example: Complete Disposal​

Marie's Catering - Year End:

Actual Overhead Costs:

  • Rent: €6,000
  • Utilities: €2,400
  • Depreciation: €1,800
  • Insurance: €1,200
  • Other: €600
  • Total Actual: €12,000

Applied Overhead:

  • Total direct labor cost: €20,000
  • Overhead rate: 50% of direct labor
  • Applied overhead: €20,000 × 50% = €10,000

Difference:

  • Actual: €12,000
  • Applied: €10,000
  • Underapplied: €2,000

Disposal (Close to COGS - simple method):

Cost of Goods Sold             €2,000
    Manufacturing Overhead                    €2,000
To close underapplied overhead

Impact on Financial Statements​

Before Disposal:

  • Manufacturing Overhead has €2,000 debit balance (underapplied)
  • Cost of Goods Sold: €50,000

After Disposal:

  • Manufacturing Overhead: €0 (closed)
  • Cost of Goods Sold: €52,000 (increased by €2,000)

Effect:

  • Underapplied overhead increases Cost of Goods Sold
  • Reduces gross profit and net income
  • More accurate cost of goods sold

Adjusting the Predetermined Rate​

If overhead is consistently underapplied or overapplied, consider adjusting the predetermined rate for the next period.

Example:

  • Consistently underapplied by 10%
  • May indicate rate is too low
  • Consider increasing rate for next period

Luxembourg Compliance Note​

In Luxembourg:

  • Underapplied/overapplied overhead must be disposed of
  • Method should be consistent
  • Consider materiality
  • Affects cost of goods sold and inventory values
  • May affect tax calculations
  • Use reasonable allocation methods

Think It Through​

Why does underapplied or overapplied overhead occur? What are the implications of each method of disposal? When would you use each method?