Over- or Under-Allocated Overhead: Videos & Practice Problems
Over- or Under-Allocated Overhead arises because applied overhead is assigned to jobs in advance using a predetermined overhead rate, while actual overhead is known only after production and actual costs are available. Since applied overhead is an estimate, it usually differs from actual overhead.
The difference is found with \( \text{Applied Overhead} - \text{Actual Overhead} \) . A positive result means overallocated overhead: too much cost was assigned to jobs because applied overhead exceeded actual overhead. A negative result means underallocated overhead: too little cost was assigned because applied overhead was less than actual overhead.
This difference matters because inventory and related costs were recorded using applied overhead rather than actual overhead. As a result, cost of goods sold is misstated until the difference is adjusted: overallocated overhead means cost of goods sold was recorded too high, while underallocated overhead means cost of goods sold was recorded too low.
Over- or Under-Allocated Overhead
Here's what students ask on this topic:
Applied overhead is the estimated overhead cost assigned to jobs using a predetermined overhead rate before production begins. It is based on expected costs and activity levels. Actual overhead, on the other hand, is the real overhead cost incurred by the company during production, which is only known after production is complete. Because applied overhead is an estimate and actual overhead is the true cost, they usually differ. This difference leads to either overallocated or underallocated overhead, which must be adjusted to accurately reflect costs in financial records.
To calculate overallocated or underallocated overhead, subtract the actual overhead from the applied overhead using the formula: . If the result is positive, it means overhead was overallocated, indicating that too much cost was assigned to jobs. If the result is negative, it means overhead was underallocated, meaning too little cost was assigned. This calculation helps managers understand how much adjustment is needed to correct cost records.
When overhead is overallocated, it means the applied overhead assigned to jobs was higher than the actual overhead incurred. As a result, the cost of goods sold (COGS) recorded during the period is too high because it includes excess overhead costs. This overstatement can distort financial statements by showing higher expenses and lower profits than actually occurred. Therefore, adjustments must be made to reduce COGS and correct the financial records to reflect the true cost of production.
Underallocated overhead occurs when the applied overhead is less than the actual overhead incurred. This means that the cost of goods sold (COGS) recorded during the period is too low because it does not include all the overhead costs. As a result, expenses are understated and profits may appear higher than they actually are. To fix this, an adjustment is needed to increase COGS and properly reflect the true production costs in the financial statements.
Adjusting for over- or underallocated overhead is crucial because inventory and cost of goods sold are initially recorded using applied overhead, which is an estimate. If this estimate differs from actual overhead, the financial statements will be inaccurate. Overallocated overhead inflates costs, while underallocated overhead understates them. Making adjustments ensures that inventory values and COGS reflect the true costs, providing accurate financial information for decision-making, reporting, and compliance with accounting standards.
