2.5 Under- or Over-applied Overhead

Since we will be using the concept of the predetermined overhead rate many times during the semester, lets review what it means again.

We know overhead is applied using estimated or budgeted overhead and a base.  Actual overhead costs may be different and we will not have all of those costs until late in the year.  Estimated may be close but is rarely accurate with what really happens, so the result is Over-applied or Under-applied Overhead.  At the end of the year, we will compare the applied overhead to the actual overhead and if applied overhead is GREATER than actual overhead, overhead is over-applied.  If applied overhead is less than actual overhead, overhead is under-applied.  But how do we correct it?

Example - Creative Printers

We learned, in the previous pages, that Creative Printers had applied overhead to Jobs 106 and 107 for a total amount of $9,850.  Actual overhead was $9,800 from indirect materials $1,000, indirect labor of $2,000 and other overhead of $6,800.  If we compare applied overhead $9,850 and actual overhead $9,000, we see a difference of $50 over-applied since the applied amount is greater than the actual overhead.   Companies generally transfer the balance of the Overhead account to Cost of Goods Sold at the end of the accounting period. Some companies do this monthly; others do it quarterly or annually. The journal entry to transfer Creative Printers’ overhead balance to Cost of Goods Sold for the month of July is as follows:

 Debit   Credit 
Overhead 50
  Cost of goods sold 50
 To record over-applied overhead. 
Why does the previous entry reduce the Cost of Goods Sold by $50? The overhead cost applied to the jobs was too high—it was overapplied. Thus, the cost of jobs was overstated or we charged to much cost to jobs. 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.

If applied overhead was less than actual overhead, we have under-applied overhead or not charged enough cost.  The entry to correct under-applied overhead, using cost of goods sold, would be (XX represents the amount of under-applied overheard or the difference between applied and actual overhead):

 Debit   Credit 
Cost of goods sold XX
  Overhead XX
 To record under-applied overhead. 
In this book, we assume companies transfer overhead balances to Cost of Goods Sold. We leave the more complicated procedure of allocating overhead balances to inventory accounts to textbooks on cost accounting.

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