Overhead Allocation:  Under-applied and Over-applied | Cost Accounting | CPA Exam BEC | CMA Exam

These lectures cover estimated predetermined factory overhead as well as underapplied overhead or overapplied overhead

Overhead Allocation | Predetermined Overhead Rate

Manufacturing overhead costs are applied to jobs using a predetermined overhead rate. Because the predetermined overhead rate is based on estimates, the actual overhead cost incurred during a period may be more or less than the amount of overhead cost applied to production. Such a difference is referred to as underapplied or overapplied overhead. The underapplied or overapplied overhead for a period can be either closed out to Cost of Goods Sold or closed proportionally to Work in Process, Finished Goods, and Cost of Goods Sold. When overhead is underapplied, manufacturing overhead costs have been understated and therefore inventories and/or cost of goods sold must be adjusted upwards. When overhead is overapplied, manufacturing overhead costs have been overstated and therefore inventories and/or cost of goods sold must be adjusted downwards.

The predetermined factory overhead rate is an estimated factory overhead rate used to apply factory overhead cost to a specific job. The application of a predetermined overhead rate has four steps: (1) estimate factory overhead costs for an upcoming operating period, usu- ally a year, (2) select the most appropriate cost driver for charging the factory overhead costs, (3) estimate the total amount of the chosen cost driver for the upcoming operating period, and (4) divide the estimated factory overhead costs by the estimated amount of the chosen cost driver to obtain the predetermined factory overhead rate.

The difference between the actual factory overhead cost and the amount of the factory overhead applied is the overhead variance; it is either underapplied or overapplied. It can be disposed of in two ways: (1) adjust the Cost of Goods Sold account or (2) prorate the difference among the Work- in-Process Inventory, the Finished Goods Inventory, and the Cost of Goods Sold accounts. Job costing is used extensively in service industries such as advertising agencies, construction companies, hospitals, repair shops, and consulting, architecture, accounting, and law firms. Operation costing is used when most of the plant’s products have a similar conversion cycle, but materials costs may differ significantly between jobs. In this case, materials costs are traced to jobs, while conversion costs are traced to departments and then to jobs.