When it comes to business costs, there are different kinds of overhead that all have their own terms and meanings. In order to understand the true cost of making goods, it is important to take into consideration the cost incurred during manufacturing for things like utilities, building expenses and salaries. For example, calculating applied manufacturing overhead means that you are including some of the overhead operating expenses of your manufacturing facility and equipment into the cost of the products you manufacture. Having an accurate idea of expenses makes it possible to more accurately determine and predict profit margins now and into the future. When you know how much it costs to produce your goods, it also becomes possible to calculate ways to cut costs and increase profits in the manufacturing process.
Over or Under, Explained
Understanding over or under-applied manufacturing overhead is less complicated than it seems. It is simply the difference between the manufacturing overhead cost applied as the job progresses, and the actual manufacturing overhead cost during a designated statement period, such as a month, quarter or year. In the case of over-applied manufacturing overhead, if a shoe company predicts $1,000,000 in manufacturing overhead in a given year but only spends $750,000, then the remaining $250,000 that was not spent is called over-applied manufacturing overhead.
On the other hand, if this same shoe company spends $1,100,000 when they only predicted $1,000,000 in manufacturing overhead expenses, the additional $100,000 spent is known as under-applied manufacturing overhead.
Normal Occurrence in Overhead
These over or under-applied overhead costs are common in manufacturing because overhead costs are calculated using estimated overhead costs. These costs are estimated ahead of time, at the beginning of a period, and apply to expected overhead costs throughout that time period. Accountants must list these expenses as they are incurred in order to facilitate the budget, but predictions are rarely 100% accurate. A good accountant knows to leave enough wiggle room in the budget to account for a margin of error in overhead predictions.
Recording Actual and Applied Cost
Another way of describing over or under-applied manufacturing overhead is the debit or credit balance of the manufacturing overhead account. Actual costs are debited as they happen. The shoe company contracts with the power company for $100,000 of estimated power costs in a given year and that cost is counted now, before the check is even sent to pay the bill. Applied costs are credited during the work as it takes place, or when the shoe company actually sends the payment to the power company. When the accounting period ends, if the overhead account has a debit balance, the overhead has been what is called under-applied. If it shows a credit balance, the overhead is over-applied.
For example, say you have a job that is estimated to cost $500,000 before it begins. You then applied $510,000 worth of inventory to the job. After the project ends, your actual overhead was $505,000. Your overhead was $5,000 over-applied.
At the Year’s End
At the end of the year, what you have left in the manufacturing overhead account can be disposed of by allocating it between several accounts. These are the work-in-process, finished goods and cost of goods sold accounts. Or, you can transfer that account only to the cost of goods sold account.
Keep the Terms Straight
One big problem with over-under overhead is keeping the terms straight. So remember that estimated overhead is the estimated figure applied to a job before it’s completed. It is used to calculate the predetermined overhead rate. Applied overhead, on the other hand, is what you spend as the work happens. Actual overhead is the real cost your company must pay out.
So whether your overhead has been over- or-under-applied, compare how much overhead was applied, which is the money spent as the work is completed, to how much was spent which gives you the total amount the company spent on overhead.