Definition
Under-applied overhead refers to a situation in cost accounting where the actual factory overhead costs incurred are greater than the allocated overhead costs charged to the products manufactured. This imbalance means that the overhead costs applied to the goods do not cover the full overhead expenses, indicating an underestimation in the overhead rate or discrepancies in production levels.
Examples
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Example A: A manufacturing company estimated its annual overhead costs to be $500,000 and applied this evenly throughout the year. However, by the end of the year, the actual overhead costs were $550,000. This difference means the company has $50,000 in under-applied overhead.
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Example B: A company uses machine hours to assign overhead costs, estimating $4 per machine hour. If the company operates for 100,000 machine hours in a year, it would apply $400,000 in overhead. If the actual overhead costs turn out to be $430,000, then there is $30,000 in under-applied overhead.
Frequently Asked Questions (FAQs)
What are the reasons for under-applied overhead?
Under-applied overhead can result from inaccurate estimations of overhead costs or actual production activities that differ significantly from planned activities, such as machinery breakdowns, unexpected maintenance costs, or inefficient labor usage.
How is under-applied overhead treated in financial statements?
Under-applied overhead is typically adjusted at the end of the accounting period. The adjustment can be made by allocating the under-applied amount to the cost of goods sold (COGS), thereby reflecting the additional costs in the period incurred.
Can under-applied overhead affect product pricing?
Yes, if a company consistently under-applies overhead, it may lead to underpriced products, eroding profit margins. Accurate overhead application ensures products are priced appropriately to cover all incurred costs.
What are the differences between under-applied and over-applied overhead?
Under-applied overhead occurs when allocated costs are less than actual expenses, whereas over-applied overhead happens when applied costs exceed actual expenditures. Both require adjustments to ensure true cost reflection in financial statements.
How do companies estimate overhead costs?
Companies estimate overhead costs through historical data analysis, budgeting for anticipated expenses, and applying rates based on cost drivers like labor hours, machine hours, or material usage.
Related Terms
- Over-Applied Overhead: The opposite of under-applied overhead, where the allocated overhead costs exceed the actual costs incurred.
- Predetermined Overhead Rate: An estimated rate used to apply overhead costs to products based on certain activities or cost drivers prior to the actual costing.
- Cost of Goods Sold (COGS): The direct costs attributable to the production of the goods sold by a company.
- Variable Overhead: Overhead expenses that vary directly with the level of production.
- Fixed Overhead: Expenses that remain constant regardless of the level of production.
Online References
Suggested Books for Further Studies
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“Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan: An authoritative book providing comprehensive coverage of cost accounting principles and practices.
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“Managerial Accounting for Managers” by Eric Noreen, Peter Brewer, and Ray Garrison: This book focuses on the needs of managerial decision-makers and provides insights into cost analysis and overhead allocation.
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“Advanced Management Accounting” by Robert S. Kaplan: An advanced text that covers the strategic role of management accounting, including cost allocation methods and overhead management.
Fundamentals of Under-Applied Overhead: Cost Accounting Basics Quiz
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