Overapplied & Underapplied Manufacturing Overhead

Introduction

In manufacturing accounting, one of the key components for determining the true cost of producing goods is the allocation of manufacturing overhead (MOH). Manufacturing overhead includes all indirect costs that are associated with the production process but cannot be directly traced to individual products. These costs typically include items such as factory rent, utilities, equipment depreciation, indirect labor, and supplies.

The process of allocating these overhead costs to individual products involves using a predetermined overhead rate (POHR), which is based on estimates made at the beginning of an accounting period. The actual overhead costs incurred during the period are compared to the applied overhead, which is the amount allocated to products based on the predetermined rate. The difference between these two figures results in either overapplied or underapplied manufacturing overhead.

Understanding the concepts of overapplied and underapplied overhead, along with their causes and implications, is crucial for manufacturing companies as it helps them accurately determine the cost of production, which in turn impacts pricing, profitability, and financial reporting.

This article will explore overapplied and underapplied manufacturing overhead in detail, including their definitions, causes, and the potential impact they have on business decisions.

1. What is Manufacturing Overhead (MOH)?

Manufacturing overhead refers to the indirect costs that are incurred during the production process but are not directly attributable to any single product. These costs are essential for the production process but are not part of the direct labor or direct materials costs. Some examples of manufacturing overhead include:

• Indirect Labor: Wages paid to employees who do not directly work on the production line, such as supervisors, maintenance workers, and quality control inspectors.
• Factory Rent and Utilities: The costs of leasing factory space and the utility bills for electricity, water, and gas used in the manufacturing process.
• Depreciation of Equipment: The gradual reduction in the value of machinery, tools, and equipment used in production.
• Supplies and Consumables: Items like lubricants, cleaning supplies, and other materials needed to maintain the production process.
• Insurance: Premiums for insurance policies that cover factory buildings, equipment, and workers.

Since overhead costs are indirect and difficult to trace directly to specific products, companies use a predetermined overhead rate to allocate these costs to the units produced.

2. What is a Predetermined Overhead Rate (POHR)?

A predetermined overhead rate is an estimate of the manufacturing overhead costs that will be incurred in a given period. This rate is calculated before the period begins, based on expected overhead costs and an appropriate allocation base. The allocation base could be direct labor hours, machine hours, or any other factor that is most closely correlated with overhead costs.

The formula for calculating the predetermined overhead rate is: {eq}POHR = \frac{\text{Estimated Manufacturing Overhead}}{\text{Estimated Activity Base (e.g., Direct Labor Hours or Machine Hours)}}{/eq}

For example, if a company estimates $500,000 in overhead costs and expects to use 100,000 direct labor hours, the predetermined overhead rate would be: {eq}POHR = \frac{500,000}{100,000} = 5 \text{ per labor hour}{/eq}

The applied overhead during the period is then determined by multiplying the predetermined overhead rate by the actual amount of the activity base used (e.g., actual labor hours or machine hours).

3. What is Overapplied Manufacturing Overhead?

Overapplied manufacturing overhead occurs when the amount of manufacturing overhead applied to products during the period exceeds the actual overhead costs incurred. This means that the company has allocated more overhead costs to its products than what was actually spent on manufacturing overhead.

Overapplied overhead is typically seen as an indication that the company has been more efficient in using its resources than originally planned. In such cases, the overhead rate set at the beginning of the period was too high in relation to the actual costs incurred.

Example of Overapplied Manufacturing Overhead:

Let’s consider a company with the following data:

• Estimated manufacturing overhead: $400,000
• Estimated labor hours: 50,000
• Predetermined overhead rate: $400,000 ÷ 50,000 = $8 per labor hour

During the period, the company applied overhead to products based on actual labor hours used:

• Actual labor hours: 55,000
• Actual manufacturing overhead costs incurred: $380,000

Now, the overhead applied to products is: {eq}\text{Applied Overhead} = 55,000 \times 8 = 440,000{/eq}

Since the actual manufacturing overhead is $380,000, but the applied overhead is $440,000, the company has overapplied its overhead by: {eq}\text{Overapplied Overhead} = 440,000 – 380,000 = 60,000{/eq}

This means that $60,000 more was applied to the products than was actually spent, which is considered overapplied overhead.

4. What is Underapplied Manufacturing Overhead?

Underapplied manufacturing overhead occurs when the amount of manufacturing overhead applied to products during the period is less than the actual overhead costs incurred. This indicates that the company has applied too little overhead to its products compared to the actual amount spent.

Underapplied overhead may suggest inefficiencies in the production process, or that the predetermined overhead rate was set too low at the beginning of the period.

Example of Underapplied Manufacturing Overhead:

Let’s take the same company but with different data:

• Estimated manufacturing overhead: $400,000
• Estimated labor hours: 50,000
• Predetermined overhead rate: $400,000 ÷ 50,000 = $8 per labor hour

During the period, the company applied overhead to products based on actual labor hours:

• Actual labor hours: 50,000
• Actual manufacturing overhead costs incurred: $450,000

Now, the overhead applied to products is: {eq}\text{Applied Overhead} = 50,000 \times 8 = 400,000{/eq}

Since the actual manufacturing overhead is $450,000, but the applied overhead is $400,000, the company has underapplied its overhead by: {eq}\text{Underapplied Overhead} = 450,000 – 400,000 = 50,000{/eq}

This means that $50,000 less was applied to the products than was actually spent, which is considered underapplied overhead.

5. Causes of Overapplied and Underapplied Manufacturing Overhead

Several factors can lead to overapplied or underapplied manufacturing overhead. These include:

Causes of Overapplied Overhead:

1. Lower-than-Expected Activity: If actual production is more efficient or uses fewer resources than estimated, the applied overhead will exceed the actual overhead costs.
2. Overestimation of Predetermined Overhead Rate: If the company overestimates the total manufacturing overhead costs at the start of the period, the applied overhead will be higher than the actual costs incurred.
3. Higher Productivity: If employees or machines work more efficiently than expected, using less time or resources than forecasted, overhead costs will be overapplied.

Causes of Underapplied Overhead:

1. Higher-than-Expected Activity: If actual production is less efficient, requiring more time or resources than anticipated, the applied overhead will be lower than the actual costs incurred.
2. Underestimation of Predetermined Overhead Rate: If the company underestimates the total manufacturing overhead costs at the start of the period, the applied overhead will be less than the actual costs incurred.
3. Lower Productivity: If employees or machines perform less efficiently than expected, using more time or resources than anticipated, overhead costs will be underapplied.

6. Implications of Overapplied and Underapplied Manufacturing Overhead

Both overapplied and underapplied overhead can have important implications for the company’s financial reporting and decision-making.

Implications of Overapplied Overhead:

1. Impact on Profits: Overapplied overhead typically results in a higher-than-expected cost of goods sold (COGS). This reduces the gross margin and profits for the period. However, the overapplied overhead must be adjusted at the end of the period to reflect the actual overhead costs.
2. Adjustment Process: At the end of the period, overapplied overhead is adjusted by either decreasing the cost of goods sold or allocating it among the ending inventory and cost of goods sold. This adjustment helps ensure that the financial statements reflect the correct expenses.
3. Potential for Increased Efficiency: Overapplied overhead can also indicate that the company is operating more efficiently than planned, which can be a positive sign.

Implications of Underapplied Overhead:

1. Impact on Profits: Underapplied overhead usually results in a lower-than-expected cost of goods sold (COGS). This increases gross margin and profits for the period. However, the underapplied overhead must be adjusted at the end of the period to reflect the actual overhead costs.
2. Adjustment Process: At the end of the period, underapplied overhead is adjusted by increasing the cost of goods sold or allocating it to the ending inventory and cost of goods sold. This adjustment ensures that the financial statements reflect the actual expenses.
3. Potential for Inefficiencies: Underapplied overhead may signal inefficiencies in the production process or poor forecasting of overhead costs. This can lead to higher costs in future periods.

7. Conclusion

Overapplied and underapplied manufacturing overhead are crucial concepts in cost accounting that directly impact the accuracy of a company’s financial statements and production cost management. Overapplied overhead occurs when more costs are allocated than were actually incurred, while underapplied overhead occurs when less is applied than incurred. Both situations require adjustments at the end of the period to reflect the true cost of production.

By carefully monitoring and adjusting for overapplied and underapplied overhead, companies can ensure that their financial reports are accurate and make more informed decisions about pricing, budgeting, and production efficiency.