Question

In Chapter 15 of your texbook, Learning Objective #5 it states:

"At the end of the year, all manufacturing overhead transactions are complete. There is no further opportunity for offsetting events to occur. At this point, Wallace Company eliminates any balance in Manufacturing Overhead by an adjusting entry. It considers under‐ or overapplied overhead to be an adjustment to cost of goods sold. Thus, Wallace debits underapplied overhead to Cost of Goods Sold. It credits overapplied overhead to Cost of Goods Sold.

After Wallace posts this entry, Manufacturing Overhead has a zero balance. In preparing an income statement for the year, Wallace reports cost of goods sold after adjusting it for either under‐ or overapplied overhead.

Conceptually, some argue that under‐ or overapplied overhead at the end of the year should be allocated among ending work in process, finished goods, and cost of goods sold. The discussion of this possible allocation approach is left to more advanced courses." If the over or underapplied overhead is material, explain why this allocation approach would be preferable.

Answer 1

Generally overheads are absorbed (or applied) using predetermined overhead rates, which is purely based on estimation. Hence, Manufacturing Overhead Account usually tends to have credit or debit balances at the end of the year which is known as under or over-applied overhead.

These under-applied or over-applied overhead cost are generally allocated using 2 methods :

1. Allocating total of under or over-applied overhead cost to 'Cost of goods Sold'.

2. Allocating under or over-applied overhead cost among work in progress, finished goods and cost of goods sold.

The second method, that is allocation of over or under-applied overhead among the work in progress, finished goods and cost of goods sold is more appropriate as it is more accurate. This methods bridge the gap between predetermined overhead rate (the estimated rate) and actual overhead.

Though, conceptually 2nd method is great, when it comes to practical aspect, most of the company prefers 1st method over 2nd method as 2nd method is very much time consuming process.

However, if accuracy of costing is given priority, one should follow the 2nd method, that is allocating over/under-applied overhead among work in progress, Finished goods and cost of goods sold.