Problems of Overhead Application - McGraw-Hill's Connect...

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Managerial Accounting
EBook
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Content
Chapter3: Systems Design: Job-Order Costing
Problems of Overhead Application
We need to consider two complications relating to overhead application: (1) underapplied and overapplied
overhead; and (2) the disposition of any balance remaining in the Manufacturing Overhead account at the
end of a period.
Learning Objective 8
Compute underapplied or
overapplied overhead cost
and prepare the journal entry
to close the balance in
Manufacturing Overhead to
the appropriate accounts.
Underapplied and Overapplied Overhead
Because the predetermined overhead rate is established before the period begins and is based entirely
on estimated data, the overhead cost applied to Work in Process will generally differ from the amount of
overhead cost actually incurred. In the case of Ruger Corporation , for example, the predetermined
overhead rate of $6 per hour was used to apply $90,000 of overhead cost to Work in Process, whereas
actual overhead costs for April proved to be $95,000 (see Exhibit 3-8 ). The difference between the
overhead cost applied to Work in Process and the actual overhead costs of a period is called either
underapplied or overapplied overhead. For Ruger Corporation , overhead was underapplied by $5,000
because the applied cost ($90,000) was $5,000 less than the actual cost ($95,000). If the situation had
been reversed and the company had applied $95,000 in overhead cost to Work in Process while incurring
actual overhead costs of only $90,000, then the overhead would have been overapplied.
What is the cause of underapplied or overapplied overhead? The causes can be complex, and a full
explanation will have to wait for later chapters. Nevertheless, the basic problem is that the method of
applying overhead to jobs using a predetermined overhead rate assumes that actual overhead costs will
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applying overhead to jobs using a predetermined overhead rate assumes that actual overhead costs will
be proportional to the actual amount of the allocation base incurred during the period. If, for example, the
predetermined overhead rate is $6 per machine-hour, then it is assumed that actual overhead costs
incurred will be $6 for every machine-hour that is actually worked. There are at least two reasons why
this may not be true. First, much of the overhead often consists of fixed costs that do not change as the
number of machine-hours incurred goes up or down. Second, spending on overhead items may or may
not be under control. If individuals who are responsible for overhead costs do a good job, those costs