To correct for overapplied overhead, the excess amount is usually subtracted from the total cost of goods sold. If the amount of overapplied overhead is significant, it may be spread out across various inventory accounts and cost of goods sold in proportion to the overhead applied during the period. The presence of overapplied overhead can significantly alter the presentation of an organization’s financial statements. When overhead is overapplied, it means that the cost of goods sold (COGS) is understated, leading to an inflated gross profit. This misrepresentation can affect various financial ratios and metrics that stakeholders rely on to assess the company’s performance.
The fact that such costs cannot be traced to results means they have to be estimated at the start of each accounting period. Recall from Chapter 1 that manufacturing overhead consists of all costs related to the production process other than direct materials and direct labor. Because manufacturing overhead costs are difficult to trace to specific jobs, the amount allocated to each job is based on an estimate. Sometimes, the actual overhead costs for a given period might be lower than what was estimated and allocated to the cost of goods or services, resulting in what is known as overapplied overhead. For example, on December 31, the company ABC which is a manufacturing company finds out that it has incurred the actual overhead cost of $9,500 during the accounting period.
These entries ensure that the financial statements accurately reflect the company’s actual costs and financial position. The process begins by identifying the amount of overapplied overhead, which is the difference between the allocated overhead and the actual overhead incurred. Once this amount is determined, it must be removed from the accounts where it was initially applied. In cost accounting, managing overapplied overhead is a critical task that can significantly influence an organization’s financial health. Overapplied overhead occurs when the allocated manufacturing overhead costs exceed the actual incurred costs during a specific period.
See it applied in this 1992 report on Accounting for Shipyard Costs and Nuclear Waste Disposal Plans from the United States General Accounting Office. Direct material costs go towards the purchase of raw materials used in the manufacturing process. A predetermined overhead rate is computed at the beginning of the period using estimated information and is used to apply manufacturing overhead cost throughout the period. In big manufacturing settings, it is impossible to avoid overapplied overhead, given that there are indirect costs that will always come into play.
On the other hand, the company can make the journal entry for underapplied overhead by debiting the cost of goods sold account and crediting the manufacturing overhead account. Although those jobs are still in Work in Process or Finished Goods Inventory, companies usually adjust the Cost of Goods Sold account instead of each inventory account. Adjusting each inventory account for a small overhead adjustment is usually not a good use of managerial and accounting time and effort. All jobs appear in Cost of Goods Sold sooner or later, so companies simply adjust Cost of Goods Sold instead of the inventory accounts.
Since we will be using the concept of the predetermined overhead rate many times during the semester, lets review what it means again. Since we will be using the concept of thepredetermined overhead rate many times during the semester, letsreview what it means again. Accruing tax liabilities in accounting involves recognizing and recording taxes that a company owes but has not yet paid. Obviously, the managerial accountants will adjust the rate based on historical and projected information.
However, the manufacturing overhead costs that it has applied to the production based on the predetermined standard rate is $10,000 for the period. Another significant implication is the need for continuous monitoring and variance analysis. Regularly comparing actual overhead costs to allocated amounts allows for timely identification of discrepancies. This proactive approach helps in making necessary adjustments before the end of the accounting period, thereby minimizing the impact on financial statements. Advanced software tools like SAP and Oracle can overapplied overhead facilitate this process by providing real-time data and analytics, enabling more informed decision-making. Overapplied overhead is the result of the manufacturing overhead costs that are applied to the production process is more than the actual overhead cost that actually incurs during the accounting period.