Definition
Underapplied overhead is a financial term used in cost accounting to describe a situation when the actual manufacturing overhead costs incurred during a given period are less than the overhead costs allocated to products or jobs in that same period. This can result from inaccurate cost estimates or from higher levels of efficiency realized during production. Ultimately, underapplied overhead leads to overestimating the actual cost of goods produced, making products costlier than they should be.
Phonetic
The phonetic pronunciation of “Underapplied Overhead” is:ʌndərəˈplaɪd ˈoʊvərˌhɛd
Key Takeaways
- Underapplied overhead occurs when a company allocates less actual overhead spending to its products or services than the incurred overhead costs in a specific period.
- It can lead to inaccurate product costing, which can impact pricing, profitability, and management decisions. Companies should identify the reasons for underapplied overhead and take corrective actions to avoid future discrepancies.
- To resolve underapplied overhead, companies can either adjust the future overhead allocation rates, prorate the underapplied overhead to the cost of goods sold and ending inventory, or close the underapplied overhead directly to the cost of goods sold, depending on the materiality of the underapplied overhead.
Importance
The term “Underapplied Overhead” is important in business and finance because it indicates that the actual overhead costs incurred by a company during a specific period have exceeded the estimated overhead costs allocated to the production process. This discrepancy can affect a company’s profitability, as it may lead to a higher cost of goods sold and reduced gross profit margins. Additionally, underapplied overhead can signal inefficiencies in the production process or inaccurate forecasting of overhead costs, prompting a need for management to reevaluate and adjust their business strategies, cost controls, and resource allocation. Careful monitoring and analysis of underapplied overhead can ultimately contribute to more informed decision-making and optimized operations, promoting the financial health and success of the company.
Explanation
Underapplied overhead is an important concept in the realm of managerial accounting and cost control. Its purpose is to measure the difference between the actual overhead costs incurred by a business and the amount of overhead allocated to products or services based on predetermined rates. As businesses strive for cost accuracy and cost control at all levels, identifying this discrepancy enables the management to make informed decisions about pricing, production, and profitability.
By examining underapplied overhead, management can determine whether the allocation methods they are using to assign overhead are accurate, and adjust them accordingly. An underapplied overhead indicates that the actual overhead costs exceeded the allocated amount, meaning the products or services were priced too low in comparison to the costs incurred. This information can aid a business in fine-tuning its operations, contributing to improved operational efficiency and cost management. Additionally, understanding the reasons behind underapplied overhead – whether it’s due to inefficient production, inaccurate budgeting, or unanticipated expenses – provides valuable insights for management, encouraging them to make proactive changes to address these issues and achieve better financial outcomes.
Examples
Underapplied overhead occurs when a company allocates less actual overhead costs to its production than the overhead costs it has incurred. This difference can influence a company’s financial reports and profitability. Here are three real-world examples of underapplied overhead:
1. Manufacturing Company: A furniture manufacturing company estimates $450,000 in overhead costs for the year. However, it incurs $500,000 in actual overhead costs. If the company only costed out $440,000 in overhead to its products, it has underapplied the remaining $60,000 in overhead costs. This underapplied overhead will result in a higher cost of goods sold and lower gross profit, if the company does not adjust for the difference at year-end.
2. Construction Firm: A construction company expects total overhead costs for a project to be $100,000. As the project progresses, the firm incurs $110,000 in actual overhead costs. If the company allocated only $95,000 in overhead costs to the project, it has an underapplied overhead of $15,000. This underapplied overhead may cause the project’s profit margins to be lower than expected and may require an adjustment to be recognized in the firm’s financial statements.
3. Textile Manufacturing: A textile manufacturer estimates $200,000 in overhead costs for the year. By the end of the year, the company incurs $220,000 in actual overhead costs but only allocated $190,000 of these costs to its products. This leads to an underapplied overhead of $30,000. As a result, the cost of goods sold on the company’s income statement will be lower, and its gross margin will appear higher than it actually is until the underapplied overhead is accounted for in the financial statements.
Frequently Asked Questions(FAQ)
What is underapplied overhead?
Underapplied overhead is a situation in which the actual overhead costs of a business are higher than the overhead costs allocated to that business during a specific accounting period. This means that the actual costs incurred were not completely accounted for in the cost of goods or services produced.
What causes underapplied overhead?
Underapplied overhead can occur due to various reasons, such as inaccurate cost estimation, unexpected increases in overhead costs, lower production levels than anticipated, or a combination of these factors.
Why is it important to identify underapplied overhead?
Identifying underapplied overhead is crucial because it affects the accuracy of financial statements and the true cost of goods or services produced. If left uncorrected, it can lead to misinformed management decisions and negatively impact the business’s profitability.
How can underapplied overhead be corrected?
To correct underapplied overhead, businesses need to adjust their financial statements at the end of the accounting period by allocating the additional costs proportionally to the cost of goods sold, work in process inventory, and finished goods inventory. This reallocation process helps to accurately reflect the true cost of production.
What are the potential consequences of not addressing underapplied overhead?
If not addressed, underapplied overhead can lead to inflated profits, incorrect pricing decisions, and ultimately a distorted picture of the company’s financial health. It may also negatively impact the business’s strategic planning, performance evaluations, and budgeting decisions.
What is the difference between underapplied and overapplied overhead?
Underapplied overhead occurs when the actual overhead costs are greater than the allocated overhead costs, meaning the actual costs incurred were not fully accounted for in the cost of goods or services produced. On the other hand, overapplied overhead occurs when the allocated overhead costs are greater than the actual overhead costs, meaning the costs allocated were more than what was actually incurred.
How can businesses minimize the risk of underapplied overhead?
To minimize the risk of underapplied overhead, businesses should regularly review and update their overhead allocation methods, conduct frequent cost analysis, and monitor production levels closely. Maintaining accurate and up-to-date records will help ensure that cost estimates and allocations are as precise as possible, reducing the chances of underapplied overhead.
Related Finance Terms
- Actual Overhead Cost
- Estimated Overhead Rate
- Cost Allocation Base
- Job Order Costing
- Overhead Variance Analysis
