Determining and Disposing of Underapplied or Overapplied Overhead in Canada

In managerial accounting, manufacturing overhead refers to the indirect costs incurred during production that cannot be easily traced to individual units produced. These costs include things like factory utilities, equipment depreciation, and factory supervisor salaries.

To allocate overhead costs to units produced, companies estimate the overhead costs for the year and divide that by an allocation base like direct labor hours to calculate a predetermined overhead rate. This rate is then used to apply overhead to jobs during production by multiplying the rate by the actual direct labor hours or machine hours used on each job.

However, the actual overhead costs incurred during the year rarely equal the amount that was applied to jobs using the predetermined rate. This results in either an underapplication or overapplication of overhead at year-end.

Underapplied vs Overapplied Overhead

If at the end of the year, the balance in the manufacturing overhead account is a debit, it means overhead has been underapplied. This indicates either:

  • Not enough overhead was applied to individual jobs during the year
  • The actual overhead costs were higher than expected

In contrast, if the balance in manufacturing overhead at year-end is a credit, overhead has been overapplied. This means:

  • More overhead was applied to jobs than was actually incurred
  • The actual overhead costs were lower than estimated

Essentially, underapplied overhead means the costs charged to production were too low, while overapplied overhead means costs charged to production were too high.

Why Overhead Application Matters

While small differences between applied and actual overhead may not significantly impact the income statement, larger discrepancies can distort product costs and lead to poor pricing and production decisions.

For example, if overhead is significantly underapplied, it means unit costs are understated in inventory. As that inventory is then sold, it shifts the underapplied costs to cost of goods sold and reduces gross profit margin for those periods.

Conversely, overapplied overhead shifts too much overhead cost into inventory, overstating inventory balances. Then as goods are sold, it shifts excessive overhead to cost of goods sold, overstating those expenses and understating margin.

To avoid distortions, companies make adjusting entries at year-end to eliminate any underapplied or overapplied overhead balances.

Disposing of Underapplied Overhead

When overhead expense has been underapplied, companies debit Cost of Goods Sold and credit Manufacturing Overhead for the amount of underapplied overhead.

For example, if a company applied $248,000 of overhead to production based on estimates, but actually incurred $250,000 of overhead costs, the entry would be:

Cost of Goods Sold $2,000 Manufacturing Overhead $2,000

This shifts the balance of underapplied overhead to cost of goods sold in the period it was incurred, matching expenses with revenues.

Some companies may do a more complicated 3-part allocation, splitting the underapplied amount between Work in Process inventory, Finished Goods inventory, and Cost of Goods Sold. This approach allocates underapplied overhead into the ending balance of inventory accounts according to how much was sitting in each at year-end.

Disposing of Overapplied Overhead

For overapplied overhead, companies credit Cost of Goods Sold and debit Manufacturing Overhead to eliminate the overapplied amount.

If a company applied $250,000 of overhead to production but only incurred $248,000 of actual overhead, the entry would be:

Manufacturing Overhead $2,000

Cost of Goods Sold $2,000

This reduces the current period's cost of goods sold to represent actual overhead incurred.

As with underapplied overhead, some firms may do a 3-part allocation between Work in Process, Finished Goods, and Cost of Goods Sold.

Overhead Analysis in Canada

Canadian managerial accounting practices closely follow those in the United States in terms of overhead application and disposition. This includes:

  • Basing predetermined overhead rates on cost estimates for the upcoming period
  • Using allocation bases like direct labor hours or machine hours to apply overhead
  • Adjusting for any underapplied or overapplied balances at year-end
  • Shifting any under/overapplied amounts to cost of goods sold and potentially inventory accounts

However, while US GAAP allows companies to shift under/overapplied overhead to just cost of goods sold, IFRS accounting rules followed in Canada require the 3-part allocation in most cases. This splits variances between work-in-process, finished goods, and cost of goods sold.

So for multinational companies operating in both countries, overhead accounting may differ slightly. But the core concepts and rationale remain the largely same. Getting actual overhead costs recognized appropriately is critical for accurate financial reporting.

Key Takeaways

  • Underapplied overhead means not enough overhead was allocated to production to cover actual overhead costs
  • Overapplied overhead arises when too much overhead was charged to jobs relative to actual overhead costs
  • These variances must be disposed to avoid distorting inventory and cost of goods sold
  • For underapplied overhead, companies debit cost of goods sold and credit manufacturing overhead
  • For overapplied overhead, companies credit cost of goods sold and debit manufacturing overhead
  • In Canada, IFRS rules generally require splitting variances over work-in-process, finished goods, and cost of goods sold

Properly accounting for manufacturing overhead is crucial for product costing. By identifying and disposing of underapplied or overapplied balances companies get a more accurate picture of true production costs each period. This enhances short and long-term decision making across the organization.

Written By:
Salman Rundhawa
Salman Rundhawa is the founder of Filing Taxes. Salman provides valuable tax planning, accounting, and income tax preparation services in Toronto, Mississauga, Oakville, and Hamilton.

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