What Is Underapplied Overhead?
Let me explain underapplied overhead directly: it's what happens when your overhead expenses end up higher than what you've budgeted for running your operations. You report this as a prepaid expense on your balance sheet, and by year's end, you balance it with a debit to the cost of goods sold, which covers the direct costs of producing goods you've sold. This amount is known as an unfavorable variance.
Key Takeaways
- Underapplied overhead means overhead expenses exceed your company's budget.
- You report this as a prepaid expense or short-term asset debit on the balance sheet, then offset it with a debit to cost of goods sold and a credit to prepaid expenses by fiscal year-end.
- It's an unfavorable variance since the business overspent its budget.
- Generally, it's not seen as negative; instead, look for patterns indicating shifts in the business environment or economic cycle.
Understanding Underapplied Overhead
Before diving into underapplied overhead, you need to grasp overhead costs. Overhead covers the expenses of running your business day-to-day, not directly tied to making a product or service. These are crucial for budgeting and setting prices to ensure profit.
Underapplied overhead hits when you haven't budgeted enough for these costs, so your actual spending outpaces the budget. Say you budget $100,000 but incur $150,000 in overhead—that leaves you with $50,000 underapplied, an unfavorable variance because costs ran higher than expected, inflating your cost of goods sold beyond projections.
As I mentioned, you list this on the balance sheet as a prepaid expense or short-term asset. To fix it, your accounting team debits cost of goods sold and credits prepaid expenses by year-end.
When this shows up in financial statements, don't panic—it's not always bad. You and your managers should hunt for patterns signaling changes in operations, the economy, or seasons. If production dips and doesn't absorb all overhead, check for reasonable causes like production snags or market variations.
Important Note on Overhead Rate
Remember, the initial predetermined overhead cost rate comes from dividing budgeted overhead costs by budgeted activity—keep this in mind as you calculate and track these figures.
Special Considerations
This analysis matters more in sectors like manufacturing, where reviewing underapplied overhead during financial planning and analysis can highlight operational or financial shifts. It helps you evaluate capital budgeting and resource allocation, from time to money to people.
Modern electronic systems for inventory and production have simplified tracking underapplied overhead, giving you better insights into key metrics.
Underapplied Overhead vs. Overapplied Overhead
Underapplied is the flip side of overapplied overhead, which occurs when actual expenses fall below your budget, meaning you underspent and have a favorable variance.
You handle overapplied differently on the balance sheet: start with a credit to overhead, then by year-end, credit cost of goods sold and debit overhead to balance it out.
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