Under-applied and Over-applied Overhead in Job Order Costing

3.5 Under-applied and Over-applied Overhead

In the realm of managerial accounting, particularly within job order costing systems, understanding how to recognize and adjust for under-applied and over-applied overhead is crucial. This section delves into the concepts, calculations, and implications of these variances, providing you with the knowledge required to manage overhead costs effectively. This understanding is not only vital for accurate financial reporting but also for making informed managerial decisions.

Understanding Manufacturing Overhead

Manufacturing overhead refers to all the indirect costs associated with the production process. These costs cannot be directly traced to specific jobs or products and include expenses such as utilities, depreciation, and salaries of maintenance staff. In a job order costing system, overhead costs are allocated to individual jobs using a predetermined overhead rate.

Predetermined Overhead Rate

The predetermined overhead rate is calculated at the beginning of an accounting period. It is based on estimated overhead costs and an estimated activity base, such as direct labor hours or machine hours. This rate is used to apply overhead costs to jobs throughout the period.

Formula:

Application of Overhead

Once the predetermined overhead rate is established, it is used to apply overhead to individual jobs. This is done by multiplying the rate by the actual amount of the allocation base incurred by each job.

Example:

If the predetermined overhead rate is $20 per direct labor hour and a job incurs 100 direct labor hours, the overhead applied to that job would be:

Under-applied and Over-applied Overhead

At the end of the accounting period, the total overhead applied to all jobs is compared to the actual overhead incurred. This comparison results in either under-applied or over-applied overhead.

• Under-applied Overhead: Occurs when the overhead applied to jobs is less than the actual overhead incurred. This indicates that not enough overhead was allocated to jobs during the period.

• Over-applied Overhead: Occurs when the overhead applied to jobs is more than the actual overhead incurred. This indicates that too much overhead was allocated to jobs during the period.

Calculating Under-applied and Over-applied Overhead

To determine whether overhead is under-applied or over-applied, follow these steps:

1. Calculate Total Applied Overhead: Multiply the predetermined overhead rate by the actual total amount of the allocation base used during the period.

2. Compare to Actual Overhead: Subtract the total applied overhead from the actual overhead incurred.

3. Determine Variance:

   • If the result is positive, the overhead is under-applied.
   • If the result is negative, the overhead is over-applied.

Example Calculation:

• Predetermined Overhead Rate: $20 per direct labor hour
• Actual Direct Labor Hours: 5,000 hours
• Total Applied Overhead: \( 20 \times 5,000 = $100,000 \)
• Actual Overhead Incurred: $110,000

Variance Calculation:

Adjusting for Under-applied and Over-applied Overhead

Adjusting for these variances is essential for accurate financial reporting. There are two primary methods for adjusting under-applied or over-applied overhead:

1. Direct Write-off to Cost of Goods Sold (COGS): This method involves adjusting the entire variance to the cost of goods sold. It is simple and commonly used when the variance is not material.

2. Proration Among Accounts: This method involves allocating the variance among work in process, finished goods, and cost of goods sold based on their relative sizes. It provides a more accurate reflection of costs but is more complex.

Practical Example of Adjusting Overhead

Consider a company with the following balances before adjustment:

• Work in Process: $50,000
• Finished Goods: $30,000
• Cost of Goods Sold: $120,000
• Under-applied Overhead: $10,000

Direct Write-off Method:

• Adjust COGS: \( 120,000 + 10,000 = $130,000 \)

Proration Method:

• Total Unadjusted Balances: \( 50,000 + 30,000 + 120,000 = $200,000 \)

• Prorate $10,000 based on these balances:

  • Work in Process: \( \frac{50,000}{200,000} \times 10,000 = $2,500 \)
  • Finished Goods: \( \frac{30,000}{200,000} \times 10,000 = $1,500 \)
  • Cost of Goods Sold: \( \frac{120,000}{200,000} \times 10,000 = $6,000 \)

Real-world Applications and Implications

Understanding and adjusting for under-applied and over-applied overhead is crucial in various real-world scenarios:

• Budgeting and Forecasting: Accurate overhead allocation helps in creating realistic budgets and forecasts, essential for strategic planning.

• Performance Evaluation: Managers use overhead variances to evaluate production efficiency and cost control measures.

• Pricing Decisions: Accurate cost information, including overhead, is vital for setting competitive and profitable prices.

Regulatory Considerations

In Canada, companies must adhere to the International Financial Reporting Standards (IFRS) or Accounting Standards for Private Enterprises (ASPE) when reporting financial information. Under-applied and over-applied overhead adjustments must be made in accordance with these standards to ensure compliance and accuracy in financial statements.

Common Pitfalls and Best Practices

• Pitfalls:

  • Failing to update the predetermined overhead rate regularly can lead to significant variances.
  • Ignoring material variances can distort financial statements and mislead stakeholders.

• Best Practices:

  • Regularly review and adjust the predetermined overhead rate based on actual data.
  • Use proration for material variances to ensure accurate cost allocation.

Conclusion

Understanding under-applied and over-applied overhead is essential for effective job order costing. By accurately calculating and adjusting these variances, you ensure precise financial reporting and informed managerial decision-making. Remember, the key to mastering this topic lies in regular practice and application of these concepts in real-world scenarios.

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