The correct proportion relating to the manufacturing unit is allocated to overhead. The balance remains on the rent expense account as a non-manufacturing overhead. Although this approach is not as common as simply closing the manufacturing overhead account balance to cost of goods sold, companies do this when the amount is relatively significant. For example, the manufacturing company ABC finds that it has a $2,000 debit balance of the manufacturing overhead at the end of the accounting period. Kraken Boardsports had 6,240 direct labor hours for the year and assigns overhead to the various jobs at the rate of $33.50 per direct labor hour.

Double Entry Bookkeeping

Instead, overhead applied represents a portion of estimated overhead costs that is assigned to a particular job. As the manufacturing overhead applied during the period is an estimate, there is usually an underapplied or overapplied overhead that needs to be reconciled at the end of the accounting period. Likewise, the journal entry will be required to reconcile the underapplied or overapplied overhead based on whether the company has the debit balance or credit balance of manufacturing overhead at the end of the period. If, at the end of the term, there is a debit balance in manufacturing overhead, the overhead is considered underapplied overhead.

By and large, production incurs three main types of expenses – labor costs, material costs, and manufacturing overhead costs. Labor and material costs, also known as direct costs, are quite easy to calculate because they are directly measurable. Overheads, on the other hand, are indirect costs that are difficult or impossible to precisely allocate per produced unit. Other examples of actual manufacturing overhead costs include factory utilities, machine maintenance, and factory supervisor salaries. All these costs are recorded as debits in the manufacturing overhead account when incurred.

Should unfavorable variance or outcomes arise—because not enough product was produced to absorb all overhead costs incurred—managers will first look for viable reasons. These may be explained by expected hiccups in production, business, or seasonal variation. Having accumulated the total amount of overhead, the next step is to find a suitable method of applying the overhead to the products. It is useful to note that some companies may use the more accurate method, but more time-consuming, to reconcile the underapplied or overapplied overhead.

Selecting an Allocation Base

When this journal entry is recorded, we also record overhead applied on the appropriate job cost sheet, just as we did with direct materials and direct labor. Figure 2.6 “Overhead Applied for Custom Furniture Company’s Job 50” shows the manufacturing overhead applied based on the six hours worked by Tim Wallace. Notice that total manufacturing costs as of May 4 for job 50 are summarized at the bottom of the job cost sheet. That part of a manufacturer’s inventory that is in the production process and has not yet been completed and transferred to the finished goods inventory.

1. Meanwhile, the production volume forecasted for the period stands at 15,000 direct labor hours.
2. The initial predetermined overhead cost rate is calculated by taking the budgeted overhead costs divided by the budgeted activity.
3. This account contains the cost of the direct material, direct labor, and factory overhead placed into the products on the factory floor.
4. In essence, the cost of goods sold is being matched with the revenues from the goods sold, thereby achieving the matching principle of accounting.

What Is Underapplied (vs. Overapplied) Overhead in Budgeting?

No matter how well-run a manufacturing company is or how good its estimations are, applied overhead is still an estimation. At the end of the year or accounting period, the applied overhead will likely not conform precisely with the actual amount of overhead costs. Let’s say a company incurred $100,000 in overheads last period and forecasts the current period to have similar numbers.

That method will not only allocate the overhead to the cost of goods sold but also to the work in process inventory account and the finished goods inventory account. Overapplied overhead occurs when expenses incurred are actually less than what a company accounts for in its budget. This means that a company comes in under budget and achieves a lower amount of overhead costs during the accounting period.

A more likely outcome is that the applied overhead will not equal the actual overhead. The following graphic shows a case where $100,000 of overhead was actually incurred, but only $90,000 was applied. Applied overhead is usually allocated out to various departments according to a specific formula.

In short, overhead is any expense incurred to support the business while not being directly related to a specific product or service. The predetermined overhead rate is therefore $100,000 divided by 15,000 which is $6.67 per direct labor hour. When deciding how to calculate factory overhead it is often necessary to apportion the total overhead cost and allocate only part of it to manufacturing. Remember that it is only the costs relating to factory personnel which are included. So for example, the management salaries will only include the cost of employees involved in the management of the factory production and manufacturing facilities. Recording the application of overhead costs to a job is further illustrated in the T-accounts that follow.

The goal is to allocate manufacturing overhead costs to jobs based on some common activity, such as direct labor hours, machine hours, or direct labor costs. The activity used to allocate manufacturing overhead costs to jobs is called an allocation baseThe activity used to allocate manufacturing overhead costs to jobs.. Once the allocation base is selected, a predetermined overhead rate can be established. The predetermined overhead rateA rate established prior to the year in which it is used in allocating manufacturing overhead costs to jobs. Is calculated prior to the year in which it is used in allocating manufacturing overhead costs to jobs.

Understanding and accurately calculating applied overhead is an invaluable tool in the managerial toolbox. This applies both to manufacturing veterans as well as newcomers just setting evolution of business and why every organization needs to embrace caring leadership up shop. While it’s just one piece of manufacturing accounting, it can significantly aid in helping the big picture come into a clearer focus. The initial predetermined overhead cost rate is calculated by taking the budgeted overhead costs divided by the budgeted activity. If the applied overhead exceeds the actual amount incurred, overhead is said to be overapplied.

Since the total amount of machine-hours used in the accounting period was 7,200 hours, the company would apply $257,400 of overhead to the units produced in that period. On the other hand, if the manufacturing overhead has a credit balance it means that that the applied overhead stage left or right meaning is more than the actual overhead. In this case, if the manufacturing overhead has a debit balance it means that that the applied overhead is less than the actual overhead.