Accountants determine the application of manufacturing overhead using a predetermined overhead rate. The organization figures out this rate at the beginning of the accounting period, so it is common for the actual amount to differ from the predetermined rate. To increase the accuracy of the cost of a product, the organization needs to correct overapplied and underapplied overhead.
During an accounting period, various situations can cause the overhead application to be over or under. One of the situations that results in misapplication of overhead is the change in overhead costs. The calculation of the rate is based on the expectation of overhead costs in the new year. Typically this is based on history, with an adjustment for known changes. If significant unexpected increases or decreases happen, then the predetermined overhead rate will not reflect current overhead costs.The predetermined overhead rate is also built on an estimation of expected sales. If sales increase or decrease, this will affect the overapplication or underapplication of overhead costs. For example, a company often applies overhead using direct labor hours. If the company expected to sell 10,000 items that each take 5 hours of direct labor with an overhead cost of $50,000, then the overhead application per direct labor hour would be $1. However, if the company sells 20,000 items and direct labor hours and overhead costs are as estimated, then there would be $100,000 in overhead costs.
Operational efficiencies (or a lack of them) can also create overapplied overhead or underapplied overhead. Using the previous example of 5 hours of direct labor per product, if the company increases efficiencies and only 4 hours are needed, then there will be underapplied overhead, which is the result of the estimated fixed costs or expenses applied being lower than the actual fixed costs or expenses for the period. In this case $1 per hour for 5 hours of manufacturing, or $5 per item, is expected to be applied. Because of the increase in efficiency to 4 hours per product, only $4 in overhead will be applied. On the other hand, an increase in the number of direct hours will create overapplied overhead, which is the result of the estimated fixed costs or expenses applied being higher than the actual fixed costs or expenses for the period.An accountant corrects the overhead application in the cost of goods calculation. To correct the general ledger in the case of underapplied overhead, the accountant would issue a debit for the cost of goods sold and a credit for manufacturing overhead. The opposite entry would be needed if overhead had been overapplied.