Definition of Underapplied Overhead
Underapplied overhead occurs when a company’s actual overhead costs exceed the overhead that was applied to production during a given period. This discrepancy leads to an unfavorable variance, indicating that the business has spent more on overhead costs than it originally budgeted. Despite the “underapplied” name sounding like your boss didn’t fill out their online shopping receipts correctly, it’s a sign of misallocated resources and potential waste in production.
Underapplied Overhead vs Overapplied Overhead
| Feature | Underapplied Overhead | Overapplied Overhead |
|---|---|---|
| Definition | Actual overhead costs exceed budgeted amounts | Budgeted overhead costs exceed actual costs |
| Variance Type | Unfavorable variance | Favorable variance |
| Impact on Financials | Increases costs on the Income Statement | Decreases costs on the Income Statement |
| Balance Sheet Treatment | Reported as a debit to COGS and prepaid expense | Adjusted and recorded as a credit |
Example
Let’s say a company budgeted $100,000 for overhead but incurred $120,000. The underapplied overhead of $20,000 will need to be adjusted on financial statements, which will require the accounting team to gather faster than a cat chasing a laser pointer!
Related Terms and Definitions
- Overhead Costs: Indirect costs related to production that cannot be directly traced, like heating bills or the fanciest coffee machine that your employees love using.
- Cost of Goods Sold (COGS): The total cost of producing goods sold, including direct and indirect costs – because there’s usually no “swift cost” shortcut here!
Illustration of Overhead Variance
flowchart TD
A[Budgeted Overhead] -->|Variances| B[Underapplied Overhead]
A -->|Variances| C[Overapplied Overhead]
B --> D{Unfavorable Variance}
C --> E{Favorable Variance}
D --> F[Increased Costs]
E --> G[Decreased Costs]
Humorous Insights
- “Underapplied overhead: because every business has that relative who always seems to overspend during the holidays…”
- “Remember that any budget variance means you’re either a genius who underspent or you need to reconsider those budget meetings after lunch!”
Frequently Asked Questions
1. What causes underapplied overhead?
- Factors such as unexpected increases in rent, maintenance costs, or personnel expenses can contribute to overhead costs exceeding budgets.
2. How can a business avoid underapplied overhead?
- Regular monitoring and adjustments to budgets, improved forecasting and cost control systems can help avert the sticky situations caused by overhead mishaps.
3. What happens if underapplied overhead goes unnoticed?
- Ignoring underapplied overhead can distort financial statements leading to poor management decisions and can make shareholders think you hired a spy to inflate costs on purpose.
References for Further Reading
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren
- Online resources like Investopedia and AccountingTools for definitions and further exploration.
Test Your Knowledge: Underapplied Overhead Challenge Quiz
## What is underapplied overhead?
- [x] Overhead costs exceeding the budgeted amount
- [ ] Overhead costs within a budget
- [ ] Any applied overhead that matched the budget
- [ ] Overhead costs that earned you a bonus
> **Explanation:** Underapplied overhead refers to a situation where actual overhead costs exceed the budgeted overhead costs.
## What type of variance is underapplied overhead considered?
- [x] Unfavorable variance
- [ ] Favorable variance
- [ ] Neutral variance
- [ ] None of the above
> **Explanation:** Since underapplied overhead means you spent more than planned, it is labeled as an unfavorable variance.
## How is underapplied overhead represented on a balance sheet?
- [ ] As a long-term asset
- [x] As a prepaid expense or short-term asset
- [ ] As equity
- [ ] As revenue
> **Explanation:** Underapplied overhead appears on the balance sheet as a prepaid expense or short-term asset until adjusted.
## When does underapplied overhead need to be adjusted?
- [ ] At the beginning of each month
- [ ] At the end of the fiscal year
- [x] Before the end of the fiscal year
- [ ] Whenever the CEO isn't paying attention
> **Explanation:** Underapplied overhead adjustments should be recorded before closing the financial books for the year.
## If a company had $30,000 in budgeted overhead but spent $35,000, what is the amount of underapplied overhead?
- [ ] $5,000
- [x] $5,000
- [ ] $7,000
- [ ] $10,000
> **Explanation:** Underapplied overhead is calculated as actual costs ($35,000) minus budgeted costs ($30,000), which equals $5,000.
## Which of the following is NOT a common cause of underapplied overhead?
- [ ] Increased utility costs
- [ ] Higher personnel costs
- [x] Improved efficiency
- [ ] Unexpected repairs
> **Explanation:** Improved efficiency typically reduces overhead costs rather than contributing to underapplying them!
## What should a company do with identified underapplied overhead?
- [ ] Ignore it and hope it goes away
- [x] Adjust it in accounting records
- [ ] Use it as an excuse for not meeting deadlines
- [ ] Hire a magician to make it disappear
> **Explanation:** The proper action is to adjust the underapplied overhead in accounting records to present an accurate picture of expenses.
## Who typically looks for patterns in underapplied overhead?
- [ ] Cat lovers
- [ ] The mailman
- [x] Analysts and Managers
- [ ] Your next door neighbor
> **Explanation:** Analysts and managers often analyze overhead variances for decision-making purposes.
## True or False: Underapplied overhead is always a sign of poor financial management.
- [ ] True
- [x] False
- [ ] Only if the printer is not working
- [ ] Maybe, if the office plants have died
> **Explanation:** While underapplied overhead indicates a variance, it can be due to various factors beyond poor management, including economic fluctuations.
Thank you for exploring the insightful world of underapplied overhead! Remember, budgeting can be as tricky as inviting an accountant to a party (they’re really good at deducting expenses!) but it’s all part of the financial learning journey. Keep striving for clarity in your financial endeavors!
