What Is Underapplied Overhead?

When overhead costs exceed a business’s budget to operate its activities, the condition is underapplied overhead. Underapplied overhead is often recorded as a company’s balance sheet prepaid charge. By the end of the year, this expense is balanced by adding a debit to the cost of goods sold (COGS) section. The direct costs incurred during the manufacturing of commodities that a business sells are known as the costs of goods sold. An unfavorable variance is the amount of underapplied overhead.

Recognizing Underutilized Overhead

It’s crucial to identify overhead expenses before examining how underapplied overhead operates. The expenses related to operating a company are referred to as overhead. To be more precise, they are costs a company bears for running its daily operations that are not directly related to producing a product or service. Businesses need to consider overhead while creating their budgets and determining how much to charge consumers to turn a profit.

Underapplied overhead happens when a company underbudges for its overhead expenses. This indicates that the business’s actual operating expenses exceed the projected amount. For instance, a business has an underapplied overhead of $50,000 if it incurs $150,000 in overhead but only budgets $100,000. This is an unfavorable variance since the planned expenses were less than the actual expenditures. Simply put, the company exceeded its budget, which increased the cost of goods sold.

As mentioned, underapplied overhead is shown on a company’s balance sheet as a prepaid expense or a short-term asset. At a later time, this balance sheet debit item needs to be balanced. The business’s accounting department often enters a debit to the COGS section by the end of the year and a credit to the prepaid costs section to reconcile this.

Underapplied overhead is often seen as good when it appears on financial statements. Instead, pattern-spotting analysts and interested managers search for indicators of potential shifts in the business environment or economic cycle. Managers will search for reasonable explanations if adverse variations or results occur, such as when insufficient product is generated to cover the associated overhead expenses. Seasonal volatility or anticipated snags in business or manufacturing may account for this.

The first predefined overhead cost rate is computed by dividing the planned overhead expenses by the budgeted activity.

Particular Points to Remember

In particular industries, like manufacturing, underapplied overhead analysis becomes more critical. Careful examination of underapplied overhead, often in routine financial planning and analysis (FP&A) tasks, may reveal significant shifts in the operational and financial landscape. These help evaluate capital budgeting choices and the distribution of scarce resources, such as money, time, and human capital.

Technological developments in electronic production management and inventory systems have significantly reduced the workload associated with thorough operational reporting, which often includes underutilized overhead analysis. These upgrades enable managers to evaluate important operational KPIs more effectively.

Comparing Overapplied and Underapplied Overhead

Underapplied overhead is the reverse of overapplied overhead. Overapplied overhead happens when expenditures incurred are less than what a corporation accounts for in its budget. This indicates that a business meets its goals and minimizes its overhead expenses for the accounting period.

Companies also need to account for overspent overhead. This is documented oppositely as underapplied overhead does on the balance sheet: it gets recorded as a credit to the overhead section at first, but toward the end of the fiscal year, it gets offset by a credit to the COGS section and a debit to the overhead section.

Conclusion

• This is underapplied overhead when overhead costs exceed a company’s actual budget.
• This amount is shown as a negative on a company’s balance sheet as a short-term asset or prepaid expenditure. A debit to the cost of goods sold before the end of the fiscal year and a credit to prepaid costs then balance it.
• An unfavorable variance occurs when a firm exceeds its budget due to underapplied overhead.
• Because analysts and managers search for patterns that might indicate changes in the business environment or economic cycle, it is often not seen negatively.