If overhead is underapplied, closing it to cost of goods sold will increase income.
What is Overhead Under Absorption and Over Absorption?When a company uses standard costing, it derives a standard amount of overhead cost that should be incurred in an accounting period, and applies it to cost objects (usually produced goods). If the actual amount of overhead turns out to be different from the standard amount of overhead, then the overhead is said to be either under absorbed or over absorbed. If overhead is under absorbed, this means that more actual overhead costs were incurred than expected, with the difference being charged to expense as incurred. This usually means that the recognition of expense is accelerated into the current period, so that the amount of profit recognized declines. Show
If overhead is over absorbed, this means that fewer actual overhead costs were incurred than expected, so that more cost is applied to cost objects than were actually incurred. This means that the recognition of expense is reduced in the current period, which increases profits. For example, if the overhead rate is predetermined to be $20 per direct labor hour consumed, but the actual amount should have been $18 per hour, then the $2 difference is considered to be over absorbed overhead. Reasons for Overhead Under Absorption and Over AbsorptionThere can be several reasons for overhead under absorption or over absorption, including the following:
How to Deal with Overhead Under Absorption or Over AbsorptionWhen under or over absorption is encountered, it is normally dealt with in one of two ways. Either the difference (either positive or negative) is charged to the cost of goods sold at once, or the difference (either positive or negative) is applied to the relevant cost objects. The first approach is easier to accomplish, but less precise. Consequently, an immediate write-off is usually limited to smaller variances, while the latter method is used for larger variances. The entire issue of overhead absorption can be reduced by using just-in-time systems to reduce the amount of inventory on hand at the end of an accounting period. By doing so, a case can be made to charge all overhead costs to expense as incurred. As you’ve learned, the actual overhead incurred during the year is rarely equal to the amount that was applied to the individual jobs. Thus, at year-end, the manufacturing overhead account often has a balance, indicating overhead was either overapplied or underapplied. If, at the end of the term, there is a debit balance in manufacturing overhead, the overhead is considered underapplied overhead. A debit balance in manufacturing overhead shows either that not enough overhead was applied to the individual jobs or overhead was underapplied. If, at the end of the term, there is a credit balance in manufacturing overhead, more overhead was applied to jobs than was actually incurred. This shows the actual amount was overapplied overhead. The actual overhead costs are recorded through a debit to manufacturing overhead. The same account is credited when overhead is applied to the individual jobs in production, as shown: Since the overhead is first recorded in the manufacturing overhead account, then applied to the individual jobs, traced through finished goods inventory, and eventually transferred to cost of goods sold, the year-end balance is eliminated through an adjusting entry, offsetting the cost of goods sold. If manufacturing overhead has a debit balance, the overhead is underapplied, and the resulting amount in cost of goods sold is understated. The adjusting entry is: If manufacturing overhead has a credit balance, the overhead is overapplied, and the resulting amount in cost of goods sold is overstated. The adjusting entry is:  Returning to our example, at the end of the year, Dinosaur Vinyl had actual overhead expenses of $256,500 and applied overhead expenses of $250,000, as shown: Since manufacturing overhead has a debit balance, it is underapplied, as it has not been completely allocated. The adjusting journal entry is: If the overhead was overapplied, and the actual overhead was $248,000 and the applied overhead was $250,000, the entry would be: To adjust for overapplied or underapplied manufacturing overhead, some companies have a more complicated, three-part allocation to work in process, finished goods, and cost of goods sold. This method is typically used in the event of larger variances in their balances or in bigger companies. (You will learn more about this in future cost or advanced managerial accounting courses.) YOUR TURNKraken BoardsportsKraken Boardsports manufactures winches for snow and ski boarders to snow ski without a mountain or water ski without a lake (Figure 8.10). End-of-year data show these overhead expenses: Kraken Boardsports had 6,240 direct labor hours for the year and assigns overhead to the various jobs at the rate of $33.50 per direct labor hour. How much overhead was overapplied or underapplied during the year? What would be the journal entry to adjust manufacturing overhead? Solution The total overhead incurred is the total of: The total overhead applied is $209,040, which is calculated as: $33.50 ÷ direct labor hours × 6,240 direct labor hours. The balance in manufacturing overhead is a debit balance of $210: The adjusting journal entry is: How does Underapplied overhead affect cost of goods sold?If overhead is underapplied, less overhead has been applied to inventory than has actually been incurred. Enough overhead must be applied retroactively to Cost of Goods Sold (and perhaps ending inventories) to eliminate this discrepancy. Since Cost of Goods Sold is increased, underapplied overhead reduces net income.
What happens if overhead is Underapplied?Accounting for Underapplied Overhead
When overhead is underapplied, the excess amount of the actual overhead cost over the amount applied may be recorded as a short-term asset, on the assumption that it will be offset in a later period by an overapplication of overhead.
Does Overapplied overhead increase cost of goods sold?When overhead has been overapplied, the proper accounting is to debit the manufacturing overhead cost pool and credit the cost of goods sold in the amount of the overapplication. Doing so results in the actual amount of overhead incurred being charged through the cost of goods sold.
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