During November, Blue River Paddle Boards incurred total actual manufacturing- overhead costs of $34,450, but only $34,200 of overhead was applied to Work-in- Process Inventory. The amount by which actual overhead exceeds applied overhead, called underapplied overhead, is calculated below.
Blue River PADDLE BOARDS
If actual overhead had been less than applied overhead, the difference would have been called overapplied overhead. Underapplied or overapplied overhead is caused by errors in the estimates of overhead and activity used to compute the predetermined overhead rate. In this illustration, Blue River Paddle Boards’ predetermined rate was underesti- mated by a small amount. Now, the estimation error needs to be corrected, in order to accurately report the actual amount of manufacturing overhead cost.
Disposition of Underapplied or Overapplied Overhead At the end of an accounting period, the company has two alternatives for the disposition of underapplied or overapplied overhead. Under the most common alternative, the underapplied or over- applied overhead is closed into Cost of Goods Sold. This is the method used by Blue River Paddle Boards, and the required journal entry is shown below.
Actual manufacturing overhead* ... $34,450 Applied manufacturing overhead† ... 34,200 Underapplied overhead ... $ 250
*Sum of debit entries in the Manufacturing-Overhead account: $200 + $14,000 + $20,250 = $34,450. See Exhibit 3–11.
†Applied overhead: $9.00 per machine hour × 3,800 machine hours.
(12) Cost of Goods Sold ... 250
Manufacturing Overhead ... 250
This entry, which is posted in Exhibit 3–11, brings the balance in the Manufactur- ing Overhead account to zero. The account is then clear to accumulate manufacturing- overhead costs incurred in the next accounting period. Journal entry (12) has the effect of increasing Cost of Goods Sold. This reflects the fact that the cost of the units sold had been underestimated due to the slightly underestimated predetermined overhead rate. If the manufacturing overhead had been overapplied, meaning that more had been applied than was actually incurred, then the journal entry would have been reversed: a debit to zero out Manufacturing Overhead and a credit to reduce Cost of Goods Sold. Most com- panies use this approach of recording the entire amount to Cost of Goods Sold because it is simple and the amount of underapplied or overapplied overhead is usually small. More- over, most firms wait until the end of the year to close underapplied or overapplied over- head into Cost of Goods Sold, rather than making the entry monthly as in this illustration.
Proration of Underapplied or Overapplied Overhead Some companies use a more accurate, but more complicated, procedure called proration to dispose of underap- plied or overapplied overhead. This approach recognizes that underestimation or over- estimation of the predetermined overhead rate affects not only Cost of Goods Sold, but also Work-in-Process Inventory and Finished-Goods Inventory. As the following diagram shows, applied overhead passes through all three of these accounts. Therefore, all three accounts are affected by any inaccuracy in the predetermined overhead rate.
Work-In-Process Inventory
Finished-Goods Inventory
Cost of Goods Sold Applied
overhead is added to work in process
Applied overhead is included in cost of goods completed
Applied overhead is included in cost of goods sold
When proration is used, underapplied or overapplied overhead is allocated among the three accounts shown above. The amount of the current period’s applied overhead remaining in each account is usually the basis for the proration procedure. In the Blue
River Paddle Boards illustration, the amounts of applied overhead remaining in the three accounts on November 30 are determined as follows:
Applied Overhead Remaining in Each Account on November 30
Account Explanation Amount Percentage*
Calculation of Percentages Work in Process ... Job D42 only ... $16,200 ... 47.37% ... 16,200 ÷ 34,200 Finished Goods ... ¼ of units in job S116 ... 4,500 ... 13.16% ... 4,500 ÷ 34,200 Cost of Goods Sold ... ¾ of units in job S116 ... 13,500 ... 39.47% ... 13,500 ÷ 34,200 Total overhead applied in November ... $34,200 ... 100.00%
*Rounded
Work-In-Process Inventory
Finished-Goods Inventory
Cost of Goods Sold Overhead
applied to job D42 16,200
Overhead applied to job S116
18,000 18,000
Applied overhead transferred to Finished Goods when job S116 was completed
18,000 13,500
Applied overhead transferred to Cost of Goods Sold when 60 out of 80 units were sold
13,500
Using the percentages calculated above, the proration of Blue River Paddle Boards’
underapplied overhead is determined as follows:
Account
Underapplied
Overhead × Percentage =
Amount Added to Account Work in Process ... $250 × 47.37% = $118.43
Finished Goods ... 250 × 13.16% = 32.90
Cost of Goods Sold ... 250 × 39.47% = 98.67
Total underapplied overhead prorated ... $250.00
If Blue River Paddle Boards had chosen to prorate underapplied overhead, the fol- lowing journal entry would have been made.
Work-in-Process Inventory ... 118.43 Finished-Goods Inventory ... 32.90 Cost of Goods Sold ... 98.67
Manufacturing Overhead ... 250.00
Since this is not the method used by Blue River Paddle Boards in our continuing illustration, this entry is not posted to the ledger in Exhibit 3–11.
Although most firms record all underapplied or overapplied overhead in Cost of Goods Sold, the proration approach is used if there is such a large amount to be adjusted that the inventory and COGS accounts would be materially misstated if the adjustment were not made. In addition, proration of underapplied and overapplied overhead is used by a small number of firms that are required to do so under the rules specified by the Cost Accounting Standards Board (CASB). This federal agency develops mandatory cost- accounting standards for large government contractors, but the standards set forth by the agency apply only to firms receiving multi-million dollar government contracts.