Disposition of under-applied or over-applied overhead depends on the significance of the amount involved. If the amount is immaterial, it is closed to Cost of Goods Sold. When overhead is under-applied (debit balance), an insufficient amount of overhead was applied to production and the closing process causes Cost of Goods Sold to increase. Alternatively, over-applied overhead (credit balance) reflects the fact that too much overhead was applied to production, so closing over-applied overhead causes Cost of Goods Sold to decrease.
To illustrate this entry, note that the Waxing and Polishing Department has an overhead credit balance at year-end of $40,000 in Manufacturing Overhead as presented in below figure (after the journal entry below); we first assume this amount to be immaterial for illustrative purposes.
The journal entry to close over-applied overhead that is assumed to be immaterial is:
[Debit]. Manufacturing Overhead = $40,000
[Credit]. Cost of Goods Sold = $40,000
If the amount of under-applied or over-applied overhead is significant, it should be allocated among the accounts containing applied overhead: Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. A significant amount of “under-applied” or “over-applied” overhead means that the balances in these accounts are quite different from what they would have been if actual overhead costs had been assigned to production.
Allocation restates the account balances to conform more closely to actual historical cost as required for external reporting by generally accepted accounting principles. The above figure uses assumed data for the Cutting and Mounting Department to illustrate the proration of over-applied overhead among the necessary accounts; had the amount been under-applied, the accounts debited and credited in the journal entry would be the reverse of that presented for over-applied overhead. A single overhead account is used in this illustration.
Theoretically, under-applied or over-applied overhead should be allocated based on the amounts of applied overhead contained in each account rather than on total account balances. Use of total account balances could cause distortion because they contain direct material and direct labor costs that are not related to actual or applied overhead. In spite of this potential distortion, use of total balances is more common in practice for two reasons: First, the theoretical method is complex and requires detailed account analysis. Second, overhead tends to lose its identity after leaving Work in Process Inventory, thus making more difficult the determination of the amount of overhead in Finished Goods Inventory and Cost of Goods Sold account balances.
Alternative Capacity Measures
One primary cause of under-applied or over-applied overhead is a difference in budgeted and actual costs. Another cause is a difference in the level of activity or capacity chosen to compute the predetermined overhead and the actual activity incurred. Capacity refers to a measure of production volume or some other activity base. Alternative measures of activity include theoretical, practical, normal, and expected capacity.
The estimated maximum potential activity for a specified time is the theoretical capacity. This measure assumes that all factors are operating in a technically and humanly perfect manner. Theoretical capacity disregards realities such as machinery breakdowns and reduced or stopped plant operations on holidays. Choice of this Reducing theoretical capacity by ongoing, regular operating interruptions (such as holidays, downtime, and start-up time) provides the practical capacity that could be achieved during regular working hours. Consideration of historical and estimated future production levels and the cyclical fluctuations provides a normal capacity measure that encompasses the long run (5 to 10 years) average activity of the firm. This measure represents a reasonably attainable level of activity, but will not provide costs that are most similar to actual historical costs. Thus, many firms use expected annual capacity as the selected measure of activity. Expected capacity is a short-run concept that represents the anticipated activity level of the firm for the upcoming period, based on projected product demand. It is determined during the budgeting process conducted in preparation of the master budget for that period.
If actual results are close to budgeted results (in both dollars and volume), this measure should result in product costs that most closely reflect actual costs and, thus, an immaterial amount of under-applied or over-applied overhead.
Accumulation Of Product Costs—Actual Cost System
Product costs can be accumulated using either a perpetual or a periodic inventory system. In a perpetual inventory system, all product costs flow through Work in Process Inventory to Finished Goods Inventory and, ultimately, to Cost of Goods Sold. The perpetual system continuously provides current information for financial statement preparation and for inventory and cost control. Because the costs of maintaining a perpetual system have diminished significantly as computerized production, bar coding, and information processing have become more pervasive, this text assumes that all companies discussed use a perpetual system.
The Royal Bali Cemerlang Manufacture Company is used to illustrate the flow of product costs in a manufacturing organization.
The April 1, 2001, inventory account balances for Royal Bali were as follows: Raw Material Inventory (all direct), $73,000; Work in Process Inventory, $145,000; and Finished Goods Inventory, $87,400.
Royal Bali uses separate variable and fixed accounts to record the incurrence of overhead. In this illustration, actual overhead costs are used to apply overhead to Work in Process Inventory. However, an additional, brief illustration applying predetermined overhead in a normal cost system is presented in the section following the current illustration. The following transactions keyed to the journal entries in the above Figure represent Royal Bali’s activity for April.
During the month, Royal Bali’s purchasing agent bought $280,000 of direct materials on account (entry 1), and the warehouse manager transferred $284,000 of materials into the production area (entry 2). Production wages for the month totaled $530,000, of which $436,000 was for direct labor (entry 3). April salaries for the production supervisor was $20,000 (entry 4). April utility cost of $28,000 was accrued; analyzing this cost indicated that $16,000 was variable and $12,000 was fixed (entry 5). Supplies costing $5,200 were removed from inventory and placed into the production process (entry 6). Also, Royal Bali paid $7,000 for April’s property taxes on the factory (entry 7), depreciated the factory assets $56,880 (entry 8), and recorded the expiration of $3,000 of prepaid insurance on the factory assets (entry 9). Entry 10 shows the application of actual overhead to Work in Process Inventory for, respectively, variable and fixed overhead for Royal Bali Cemerlang during April. During April, $1,058,200 of goods were completed and transferred to Finished Goods Inventory (entry 11). Sales of $1,460,000 on account were recorded during the month (entry 12); the goods that were sold had a total cost of $1,054,000 (entry 13). An abbreviated presentation of the cost flows is shown in selected T-accounts below.
If you have not had a chance to read my two previous posts [Accumulation And Allocation Of Overhead Cost and Applying Overhead Cost To Production Cost ], consider to read them. They are both on topic. Enjoy!