The Effect of Under- and Overapplied Overhead on Net Operating Income
If overhead is underapplied, less overhead has been applied to inventory than has
actually been incurred. Enough overhead must be added to Cost of Goods Sold (and
perhaps ending inventories) to eliminate this discrepancy. Since Cost of Goods Sold is
increased, underapplied overhead reduces net income.
If overhead is overapplied, more overhead has been applied to inventory than has
actually been incurred. Enough overhead must be removed from Cost of Goods Sold
(and perhaps ending inventories) to eliminate this discrepancy. Since Cost of Goods
Sold is decreased, overapplied overhead increases net operating income.
The Predetermined Overhead Rate and the Level of Activity (Appendix 3A).
(Exercise 3-16.) Interest has been recently rekindled in the issue of how to select the
denominator level of activity in the predetermined overhead rate. In the main body of the
chapter, it is assumed that the denominator is the estimated total amount of the allocation base
for the period. While this is the most common method used in practice, it has some serious
Drawbacks of basing the predetermined overhead rate on the estimated level of
If overhead contains substantial fixed costs, then as the estimated level of activity
decreases, the predetermined overhead rate will increase. Thus if the company starts
losing sales due to a recession or other reason, the company’s unit costs will increase.
This could result in some managers increasing prices or dropping products, which is
likely to be exactly the wrong thing to do in this situation.
Products are charged with resources they don’t use. If a product uses 10% of the
capacity of a fixed resource, it is argued that it should be charged with only 10% of the
cost of that resource. If all of the products a company makes use only 50% of the
capacity of the fixed resource, the cost of that idle capacity should be separately
recognized as a period expense rather than spread over the products that use the
resource during the period. Under the conventional approach, products are charged for
both their share of the capacity they use and for a share of the idle capacity they do not
use. So if a product uses 10% of the capacity of a resource, but 50% of the capacity is