Manufacturing overhead encompasses all manufacturing costs that are not attributed back to a specific job. Due to the difficulty of accurately predicting the amount of manufacturing overhead that will be used throughout the year, it is common to incur over- or underapplied manufacturing overhead at the fiscal year end. This amount must be accounted for in order to balance the financial statements.
Causes of Underapplied Manufacturing Overhead
Unlike other components of job costing, such as labor and material costs, manufacturing overhead is estimated and allocated based on a predetermined overhead rate. Discrepancies occur because it is difficult to forecast. Underapplied overhead may appear when the overhead rate is not accurate, the initial estimate for a job was too low or if overhead spending wasn't monitored and controlled during job completion.
Recording Underapplied Manufacturing Overhead
As a job progresses, actual overhead is recorded on the debit side of the manufacturing overhead account. Overhead costs are multiplied by the predetermined overhead rate and recorded on the credit side of the work in progress inventory account for a balancing entry. Once the products are sold, the cost of goods sold increases. Underapplied manufacturing overhead results when the actual overhead exceeds the overhead applied to the job.
Accounting Treatment of Underapplied Manufacturing Overhead
The most common accounting treatment for underapplied manufacturing overhead is to close it out to cost of goods sold. This reflects the fact that the actual cost to produce the goods sold was higher than anticipated. Since the manufacturing overhead account is in a debit position, another entry is required to balance the books, so cost of goods sold is credited. Manufacturing overhead should then balance to zero.
Effect of Underapplied Manufacturing Overhead
When the cost of goods sold increases, net income is reduced because there is less profit from the sale of the product. Critics of this accounting method of dealing with underapplied manufacturing overhead say it should be recorded on the income statement under cost of unused capacity to make it less complicated to see.
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