Why do companies apply overhead to jobs using a predetermined overhead rate instead of applying actual overhead to jobs?

In the previous post, we discussed using the predetermined overhead rate to apply overhead to jobs. This applied overhead is an approximation. What about actual spending for overhead costs? Let’s review how we got applied overhead.

First, we calculated the predetermined overhead rate by dividing estimated overhead by estimated activity.

Then we multiplied the predetermined overhead rate by the actual activity to calculate applied overhead.

So far, we haven’t used a single actual overhead figure in our calculations. Actual overhead is the amount that the company actually incurred. Imagine that there are two groups of accountants inside a company. One group  is applying overhead based on the actual activity and the predetermined overhead rate. These accountants are adding direct materials, direct labor and applied overhead to jobs to calculate the cost of goods sold on every job that is sold. The second group of accountants is recording actual bills and totalling up actual overhead costs. Except these actual overhead costs are not included in cost of goods sold. They are held off to the side. At the end of the year, the applied accountants and the actual accountants come together to reconcile cost of goods sold to ensure that the actual numbers are what ends up in cost of goods sold at the end of the year.

Overapplied or Underapplied?

What do we do when we have the actual overhead numbers? We need to compare the actual overhead incurred to the applied overhead that is currently attached to our jobs. We need to see if we applied too much overhead or too little overhead to our jobs.

If too much overhead has been applied to the jobs, we say that overhead is overapplied. If too little overhead has been applied to the jobs, we say that overhead is underapplied. I like to figure this out before I even calculate the dollar figure. Compare applied overhead to actual overhead. Have you applied too much or too little? Remember that applied overhead is what is in cost of goods sold right now. We need to adjust cost of goods sold to actual at the end of the year.

Once you have determined if overhead is underapplied or overapplied, Calculate the difference between applied overhead and actual overhead. This is the amount that you must adjust cost of goods sold to bring it to the actual cost.

If overhead is overapplied, meaning you have too much overhead in cost of goods sold, subtract the amount that is overapplied.

If overhead is underapplied, meaning you have too little overheard in cost of goods sold, add the amount that is underapplied.

Let’s look at an example to help clarify all this.

Example #1

K’s Kustom Furniture estimated overhead at the beginning of the year to be $567,000. Over the course of the year, K’s applied $578,000 worth of inventory to it’s jobs. At the end of the year, actual overhead incurred was $572,000. Calculate the amount of overhead that was overapplied or underapplied. How much cost of goods sold should be reported if unadjusted cost of goods sold is $2,134,000?

We’ve got a lot of figures for such a short problem. We have three overhead figures. This is why knowing the terminology is really important. If you have the terminology clear, this problem is easy. First, let’s review the terminology.

Estimated overhead is budgeted at the beginning of the year and used to calculate the predetermined overhead rate. Applied overhead is the amount that is added to jobs as work is completed. This is done during the year as work is completed using the predetermined overhead rate and actual activity. Actual overhead is the amount of overhead cost that the company actually incurred.

When determining if overhead has been overapplied or underapplied, we have to compare how much overhead has been applied to how much was actually incurred. Applied overhead is $578,000. Actual overhead is $572,000. Estimated overhead is not used here. Remember that estimated overhead is ONLY used to calculate the predetermined overhead rate.

First determine if overhead is overapplied or underapplied. Actual overhead is what should be in cost of goods sold. Applied overhead is what is currently in the account. So right now, there is $578,000 in the account but there should be $572,000. Is there too much overhead or too little overhead? There is too much overhead. If we do the math, there is $6,000 too much in cost of goods sold.

Therefore, overhead is $6,000 overapplied.

That also means that cost of goods sold is $6,000 too high. When overhead is overapplied, we must subtract the amount from cost of goods sold.  Cost of goods sold is currently overstated.

$2,134,000 – $6,000 overapplied overhead = $2,128,000 adjusted cost of goods sold.

Final Thoughts

This post may seem like overkill, but I can’t tell you how many times I’ve seen students get these problems wrong because they did not know the terminology. I often see students confuse estimated and applied overhead. Make sure you know the terminology and the rest of this is easy.

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