2. What two methods can companies use to dispose of under- and overapplied overhead?
G U I D E D U N I T P R E P A R A T I O N
We have seen that during the accounting period, manufacturing overhead is applied to work in process using a predetermined overhead rate that is based on estimates of total manufacturing overhead and activity. It is unlikely,
therefore, that at the end of the accounting period the actual overhead in- curred during the period will equal the applied overhead for the period.
That is, instead of equaling zero, the Manufacturing Overhead Control ac- count will show a balance. This control account is just a temporary account that is used to keep track of overhead costs. Because the amount isn’t re- ported separately in the financial statements, it needs to have a zero balance by the end of the accounting period. The way to reduce the account balance to zero is to make an adjusting entry to the Manufacturing Overhead Con- trol account.
To determine the amount of the adjustment, look at the balance in the Manufacturing Overhead Control account. If the balance is a debit, more overhead was actually incurred than was recorded in the Work in Process In- ventory account during the period. The result is underapplied overhead—that is, not enough overhead cost was charged to products as they were made. As a result, the inventory cost is too low and needs to be increased. If the balance in the account is a credit, on the other hand, more overhead was recorded in the Work in Process Inventory account than was actually incurred during the period. The result is overapplied overhead. Since the cost that was recorded in the inventory account is too high, the inventory cost needs to be decreased.
Exhibit 4-16 summarizes the relationship between actual and applied manu- facturing overhead.
Closing Underapplied and Overapplied Overhead to Cost of Goods Sold
If the amount of underapplied or overapplied manufacturing overhead is small, most companies will make the entire adjustment to cost of goods sold. The jus- tifi cation is that by the end of the period most of the inventory that was incor- rectly costed has been sold and the adjustment amount is small compared to the total inventory value. To make this kind of adjustment, one of the following journal entries should be recorded for the amount of underapplied or overap- plied manufacturing overhead:
Notice that when manufacturing overhead is underapplied (left column), Cost of Goods Sold is debited. Cost of Goods Sold is an expense account that normally has a debit balance. If this account is debited, it is increased, recognizing that not
To Adjust for Underapplied Overhead Cost of Goods Sold xxx
Manufacturing Overhead Control xxx
To Adjust for Overapplied Overhead Manufacturing Overhead Control xxx Cost of Goods Sold xxx Debit Balance Manufacturing Overhead
UNDERAPPLIED Actual OH > applied OH; overhead has been
ACTUAL MOH Ending Balance
Ending Balance APPLIED
MOH
(Not enough manufacturing overhead has been added to product costs)
Credit Balance
OVERAPPLIED Actual OH < applied OH; overhead has been
(Too much manufacturing overhead has been added to product costs)
EXHIBIT 4-16 Underapplied and overapplied overhead.
Unit 4.4 Underapplied and Overapplied Manufacturing Overhead 157 enough overhead has been recorded in the fi nancial records. Alternatively, when
manufacturing overhead is overapplied (right column), Cost of Goods Sold is credited, or decreased, recognizing that too much overhead has been recorded in the fi nancial records.
Let’s look at an example. By the end of the year, C&C Sports had applied
$1,043,526 of manufacturing overhead costs to work in process. The company had actually incurred $1,063,108 in manufacturing overhead costs. Since ac- tual manufacturing overhead exceeded the amount of overhead applied during the year, overhead was underapplied by $19,582, and inventory costs recorded during the year were too low. For the inventory accounts to refl ect the actual overhead costs incurred, C&C Sports should make the following journal entry:
Cost of Goods Sold $19,582
Manufacturing Overhead Control $19,582
Prorating Underapplied and Overapplied Overhead
If the amount of underapplied or overapplied manufacturing overhead is rela- tively large, the more appropriate treatment is to prorate the amount to all the accounts that contain applied overhead—Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. The proration should be based on the relative size of the ending balance in each account.
The fi rst step in prorating underapplied or overapplied overhead is to add together the ending balances in the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Next, calculate the percentage of the total represented by each of the three accounts. Finally, multiply each per- centage by the underapplied or overapplied amount to determine how much overhead should be charged to each account. Exhibit 4-17 shows how the pro- ration would be done using the same amount as in the previous example (with
$19,582 in underapplied manufacturing overhead).
Notice that with either approach (closing the entire amount to Cost of Goods Sold or prorating it), the balance in the Manufacturing Overhead Control ac- count will be zero after the adjusting entry has been posted. The zero balance indicates that actual overhead cost and applied overhead cost are equal, so that all inventory is refl ected at actual cost.
a$6,137 4 $4,310,267 5 0.14%.
b$19,582 3 0.14% 5 $27.
Percentage Prorated Overhead Account Ending Balance of Total Amount
Work in process $ 6,137 0.14%a $ 27b Finished goods 447,280 10.38% 2,033 Cost of goods sold 3,856,850 89.48% 17,522
$4,310,267 100.00% $19,582
The three different overhead terms that you have just learned cannot be used interchangeably. Make sure you can distinguish among them:
Actual overhead—the amount of overhead costs that the company really pays for. (For C&C, $1,063,108 in 2013).
Estimated overhead—the amount of overhead that the company expects to incur during the year. This amount is used only at the beginning of the accounting period, to determine the predetermined overhead rate. (Estimated by C&C at $1,056,000 at the beginning of 2013).
Applied overhead—the amount of overhead that is charged to Work in Process Inventory. It equals the predetermined overhead rate times the actual application base incurred by the company.
(For C&C, $1,043,526 by the end of 2013).
WATCH OUT!
EXHIBIT 4-17
C&C Sports’ proration of underapplied overhead.
Exhibit 4-18 summarizes C&C’s cost fl ows for 2013 based on the following events. Compare the balances in the T-accounts in Exhibit 4-18 to C&C Sports’
fi nancial statements, shown in Topic Focus 1, Exhibits T1-3 on page 37 and T1-4 on page 38.
Materials purchased $2,591,108
Materials used ($2,053,239 direct; $519,342 indirect) 2,572,581 Wages/Salaries paid ($834,821 direct; $211,023 indirect) 1,045,844
Factory equipment depreciation recorded 52,175
Factory rent paid 110,000
Utilities paid 57,420
Insurance paid 54,661
Other factory costs incurred 58,487
Overhead charged to work in process at 125% of direct labor
cost ($834,821 3 125%) 1,043,526 Finished:
202,000 pants at a total cost of $1,993,740 70,000 jerseys at a total cost of $781,900
15,000 jackets at a total cost of $1,156,800 $3,932,440 Sold:
200,000 pants at a total cost of $1,974,000 65,000 jerseys at a total cost of $726,050
15,000 jackets at a total cost of $1,156,800 $3,856,850 Underapplied overhead charged to Cost of Goods Sold $ 19,582 Raw Materials Inventory
168,428 2,591,108
6,991 2,053,239 834,821 1,043,526 2,572,581
186,955
Work in Process Inventory
3,932,440
6,137
519,342 211,023 52,175 110,000 57,420 54,661 58,487
Manufacturing Overhead Control
1,063,108 19,582
0 0
1,043,526 1,043,526
19,582
Finished Goods Inventory 371,690
3,932,440 3,856,850
447,280
3,876,432
Cost of Goods Sold
3,856,850 19,582
EXHIBIT 4-18 Manufacturing cost fl ow summary for C&C Sports, 2013.
Why is underapplied or overapplied overhead never charged to Raw Materials Inventory?