Question

What is under applied overhead and What is over applied overhead? What disposition is made of these amounts at the end of the period?

Answer 1

An organization which wants to do Cost management always develops and uses pre-applied overhead rates for allocation to its products. As a part of Cost management exercise organization develops Budgets at the beginning of the year. Overheads developed as part of this budget are used to calculate pre-determined overheads with the help of machine hours or labor hours budgeted during the year. These pre-determined overheads are then applied to products/services during the year to arrive at the costing of products/services. Also these pre-determined overhead helps the organization in pricing decisions. Some organizations implement Standard Costing system and develop pre-determined standard rates also for controlling overheads.

The most common method of pre-determined overhead rate is based on machine hours. The machine hours simply represent the total number of hours the machine is in operation during the year. With the manufacturing overhead costs and the machine hour totals, we can calculate the predetermined overhead rate by dividing the total overhead costs by the machine hours. For instance, if the manufacturer estimates $20,000 in overhead costs with 40,000 machine hours, the predetermined overhead rate is 50 cents per unit.

Actual Overhead Costs

Since the predetermined manufacturing overhead rate is an estimate, it is important to identify the actual overhead rate at the end of the reporting period. The actual overhead costs used during the period are the manufacturer’s absorbed overhead. To determine the absorbed overhead amount, multiply the actual number of machine hours used during the term by the predetermined overhead rate,.

Example of Application of pre-determined overhead rate

The previous example identified the predetermined overhead rate for machine hours at 50 cents per unit. At the end of the 12-month reporting period, the manufacturer determined that the business actually used 41,000 machine hours, which is 1,000 more than budgeted. To determine the actual overhead costs absorbed by the manufacturer, multiply the actual 41,000 machine hours by the overhead absorption rate of 50 cents per unit. The actual overhead absorbed is $20,500, or $500 more than anticipated.

Since the amount of actual overhead is more than the budgeted overhead, the manufacturer has over-absorbed its overhead costs. Had the manufacturer’s overhead costs totaled less than the estimated costs, the manufacturer would have under-absorbed its overhead costs. For example, if business actually used 38,000 machine hours the overhead absorbed would have been $19,000. To that extent there would have been under-absorbed overheads of $1,000.

The over or under-applied manufacturing overhead is defined as the difference between manufacturing overhead cost applied to products/services and manufacturing overhead cost actually incurred during a period

At the end of the year, the balance in manufacturing overhead account (over or under-applied manufacturing overhead) is disposed off by either allocating it among work in process, finished goods and cost of goods sold accounts or transferring the entire amount to cost of goods sold account.