What is ‘Underapplied Overhead’
In cost accounting, an accounting record is created when the overhead costs ascribed to a work-in-progress product do not equal the amount of real overhead expenses incurred. In the company’s balance sheet, underapplied overhead is recorded as a deferred expenditure, and at the end of the year, it is balanced by posting a credit to cost of goods sold. The direct cost involved with the manufacture of items sold by a corporation is referred to as the cost of goods sold. An unfavorable variance is defined as the amount of underapplied overhead that results in a profit.
Explaining ‘Underapplied Overhead’
For example, a $100,000 overhead expense was spent, but only $90,000 was allocated to the project. Unfavorable variance is referred to as such because it indicates that the product’s planned costs were lower than the actual costs, and as a result, the product’s cost of goods sold was higher than anticipated.
The first predefined overhead cost rate is obtained by dividing the planned overhead expenses by the budgeted activity, which is the same as the budgeted overhead cost rate.
Underapplied overhead is recorded as a deferred expenditure on the balance sheet
Underapplied overhead occurs when a business does not allocate enough money towards its overhead costs and thus the actual amount incurred is less than the budgeted amount. Often, the management uses the standard allocation method instead of adjusting the actual expenditure to account for any future changes in the overhead costs. The standard allocation is generally based on the historical costs incurred at the factory and is adjusted to account for the projected changes in those costs during the next year.
The underapplied amount is not a negative event, but analysts and managers look for patterns in the amount of over and under-applied overhead. Underapplied overheads point to changes in the business environment and in the economic cycle. Under-applied overheads also point to variances in production, and managers try to find reasons for them. They could be the result of seasonal variation or expected hiccups in production.
In some cases, underapplied overhead is a reflection of under-applied overhead. The company incurred costs related to manufacturing but underestimated the amount. In this case, the company estimated its total overhead to be $110,000, based on a predetermined rate of overhead per direct labor hour. However, the actual amount of overhead was only $106,000. If this scenario is repeated in the same way, under-applied overhead is a deferred expenditure on the balance sheet.
It is recorded as a deferred expenditure on the balance sheet
Underapplied overhead is a variance that occurs when a business does not budget enough for its overhead costs. This means that the amount budgeted is less than what the business actually spends. In this example, if a company budgets $150,000 for overhead, but only spends $100,000, underapplied overhead is $50,000. This is known as an unfavorable variance.
Underapplied overhead is a negative event in the balance sheet, but it does have a different meaning in manufacturing companies. This is because underapplied overhead can indicate meaningful changes in the business’ financial or operational conditions. It is particularly useful when evaluating capital budgeting decisions and allocation of limited resources. Many production management systems and electronic inventory systems have greatly reduced the burden of producing detailed, comprehensive operational reporting. Managers can more easily assess key operational metrics when they have accurate and comprehensive information at their fingertips.
Underapplied overhead is a type of expense recorded on the balance sheet that has not been paid yet. Unlike prepaid expenses, deferred expenses are not reported on the income statement until they are incurred. In contrast, deferred revenues are considered revenue when they are not paid until the revenue is earned. Therefore, they are recorded on the balance sheet as a liability. When the revenue is realized, the asset is increased, and the liability account decreases.
It is recorded as a deferred expenditure on the income statement
Overhead expenses are often over budget, so underapplied overhead can occur. In order to avoid an underapplied overhead situation, a business should record the excess amount as a prepaid expense on its accounting ledger. However, it may also record some of the underapplied overhead as a cost of goods sold on its income statement, which reduces its net income. How should underapplied overhead be allocated?
Underapplied overhead is a deferred expense, but it is recorded on the income statement as an expense. Underapplied overhead is balanced by posting a credit to the cost of goods sold, the direct costs associated with manufacturing goods. The difference between the two amounts is known as an unfavorable variance. When underapplied overhead results in a profit, the business should record it as a deferred expense.
Overapplied overhead on the income statement is a form of unaccounted for expense. It is the difference between the actual costs incurred and the overhead applied. Underapplied overhead is generally recorded as a deferred expense on the income statement. For example, Tasty Turtle estimates that the amount of overhead will be $75,000 in the next year. However, the actual cost of manufacturing will be $106,000.
Underapplied Overhead FAQ
What happens if manufacturing overhead is Underapplied?
It is possible to have underapplied manufacturing overhead when the planned manufacturing overhead is less than the actual manufacturing overhead spent on manufacturing. Underapplied overhead is recognized as a prepaid expenditure on the balance sheet and is subsequently rectified by raising the cost of products sold at the conclusion of the time period in which the expense occurred.
How do you calculate Underapplied overhead?
To calculate the applicable overhead costs, subtract the planned overhead costs from the actual overhead expenses in the previous month. The difference between $10,000 and $8,000 is $2,000 in underapplied overhead in our hypothetical case.
How does Underapplied overhead affect gross profit?
Underapplying overhead means that a lower amount of overhead has been applied to inventory than has actually been expended. In order to remove this mismatch, sufficient overhead must be charged retrospectively to Cost of Goods Sold (and maybe ending inventories) in order to close the gap. Because the cost of goods sold has grown, underapplied overhead has resulted in a decrease in net revenue.
