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4. Accounting for Actual and Applied Overhead

A lot of this chapter has been devoted to discussing the application of overhead to production. Overhead is applied based on a predetermined formula, and considerable thought needs to be put into the appropriate basis (cost drivers) for making this allocation. An account called "Factory Overhead" is credited to reflect this overhead application to work in process.

But, what is the source of the debits to Factory Overhead?

4.1. The Factory Overhead Account

The Factory Overhead account is not a typical account. It does not represent an asset, liability, expense, or any other element of financial statements. Instead, it is a "suspense" or "clearing" account. Amounts go into the account and are then transferred out to other accounts. In this case, actual overhead goes in, and applied overhead goes out! The credits to this account are generated when overhead is applied to production; now focus on the debits which represent the actual amounts being spent on overhead.

4.2. Actual Overhead

As the cost components of overhead are actually incurred, the Factory Overhead account is debited, and the logically offsetting accounts are credited. The table below provides representative examples of factory overhead items.

EXAMPLE OVERHEAD ITEM

DEBIT

CREDIT

Indirect labor

Factory Overhead

Salaries Payable

Indirect material

Factory Overhead

Inventory or Supplies

Insurance

Factory Overhead

Prepaid Insurance

Factory depreciation

Factory Overhead

Accumulated Depreciation

Taxes

Factory Overhead

Taxes Payable

Utilities

Factory Overhead

Utilities Payable

The indirect labor would relate to the cost of factory staff not directly involved in production. This can include break-time of line workers, shop managers, maintenance, guards, and so forth. The indirect materials relates to supplies and components that are not a significant cost item. Importantly, selling and administrative costs not related to production (e.g., advertising, salaries for non-production related staff, sales commissions, rent of the corporate offices, etc.) are separately expensed, and are not part of factory overhead. A typical entry to record factory overhead costs would be as follows:

6-30-X3

Factory Overhead

100,000

Salaries Payable

50,000

Supplies

15,000

Prepaid Insurance

5,000

Accumulated Depreciation

11,000

Taxes Payable

9,000

Utilities Payable

10,000

To record various factory overhead costs

4.3. The Balance of Factory Overhead

Since the Factory Overhead account is debited for actual overhead incurred and credited for allocated overhead, the general ledger account would appear as follows (the job costs are newly assumed for this illustration):

ACCOUNT: Factory Overhead

Date

Description

Debit

Credit

Balance

June 5, 20X3

Allocated overhead to Job A

_____

$ 15,000

$ 15,000

June 7, 20X3

Allocated overhead to Job B

10,000

25,000

June 8 to 30

Allocated overhead to Job C, D, etc.

75,000

100,000

June 30, 20X3

Recorded actual overhead (see entry)

$ 100,000

-

The next graphic provides a visual representation of the cost flow associated with the Factory Overhead account. In this case, the applied overhead equaled the actual overhead, leaving a zero balance. This means that the predetermined allocation rate was exactly what was incurred during the period. More often than not, this level of perfection will not result.

factory overhead

4.4. Underapplied Overhead

A more likely outcome is that the applied overhead will not equal the actual overhead. The following graphic shows a case where $100,000 of overhead was actually incurred, but only $90,000 was applied.

This situation is called "underapplied" overhead. It is said to be an "unfavorable" outcome, because not enough jobs were produced to absorb all of the overhead incurred. This might result from below normal levels of output, or overspending. In any event, the fact remains that more was spent than allocated. Because the Factory Overhead account is just a clearing account (not a financial statement account), the remaining balance must be transferred out. Several options are available for disposing of this amount, but one approach is to remove (credit) the underapplied amount and charge (debit) Cost of Goods Sold:

6-30-X3

Cost of Goods Sold

10,000

Factory Overhead

10,000

To transfer underapplied overhead to cost of goods sold

This entry has the effect of reducing income for the excessive overhead.

4.5. Overapplied Overhead

If the applied overhead exceeds the actual amount incurred, overhead is said to be "overapplied." This is usually viewed as a favorable outcome, because less has been spent than anticipated for the level of achieved production.

The next journal entry shows the reduction of cost of goods sold to offset the amount of overapplied overhead:

6-30-X3

Factory Overhead

10,000

Cost of Goods Sold

10,000

To reduce cost of goods sold for the overapplied overhead

Always keep in mind that the goal is to "zero out" the Factory Overhead account and measure the actual cost incurred. In this last example, $100,000 was actually spent and accounted for: $110,000 charged to specific jobs and $10,000 offset as a reduction in cost of goods sold.

These illustrations of the disposition of under- and overapplied overhead are typical, but not the only available solution. A more theoretically correct approach would be to reduce cost of goods sold, work in process inventory, and finished goods inventory on a pro-rata basis. However, this approach is clearly more cumbersome and can sometimes run afoul of the specific accounting rules discussed in the next paragraph. In a subsequent chapter, you will learn more about how to handle the "variances" arising from underapplied overhead.

4.6. Influence of GAAP

Although managerial accounting information is generally viewed as for internal use only, be mindful that many manufacturing companies do prepare external financial statements. And, generally accepted accounting principles dictate the form and content of those reports. For example, a specific Statement of the Financial Accounting Standards Board (SFAS No. 151) requires that underapplied overhead relating to idle facilities, wasted material, the allocation of fixed production overhead, and so forth, be charged to current period income by means similar to those just illustrated.

 
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