Predetermined overhead rate | Overapplied & underapplied overhead | Cost Accounting | CPA Exam BAR
Channel: Farhat Lectures. The # 1 CPA & Accounting Courses
Date: 2020-10-08

A predetermined overhead rate is an allocation rate that is used to apply the estimated cost of manufacturing overhead to cost objects for a specific reporting period. The concept of predetermined overhead rate is very important because it is used most of the enterprises as it enables them to estimate the approximate total cost.

✔️Accounting students and CPA Exam candidates, check my website for additional resources:  https://farhatlectures.com/
📧Connect with me on social media: https://linktr.ee/farhatlectures


#cpaexam #costaccounting#accountingstudent

What Is Underapplied Overhead?
The term underapplied overhead refers to a situation that arises when overhead expenses amount to more than what a company actually budgets for in order to run its operations. Underapplied overhead is normally reported as a prepaid expense on a company's balance sheet and is balanced by inputting a debit to the cost of goods sold (COGS) section by the end of the year. Costs of goods sold are the direct cost associated with the production of goods sold by a company. The amount of underapplied overhead is referred to as an unfavorable variance.


Understanding Underapplied Overhead
Before looking at how underapplied overhead works, it's important to define overhead costs. The term overhead is used to describe the costs associated with running a business. More specifically, these are expenses that a business incurs for its day-to-day operations but are not directly linked to the creation of a product or service. Overhead is important for businesses for a number of reasons including budgeting and how much to charge their customers in order to realize a profit.


Underapplied overhead occurs when a business doesn't budget enough for its overhead costs. This means the budgeted amount is less than the amount the business actually spends on its operations. For example, when a company incurs $150,000 in overhead after budgeting only $100,000, it has an underapplied overhead of $50,000. This is referred to as an unfavorable variance because it means that the budgeted costs were lower than actual costs. Put simply, the business went over budget making the cost of goods sold more than expected.


 The initial predetermined overhead cost rate is calculated by taking the budgeted overhead costs divided by the budgeted activity.
As noted above, underapplied overhead is reported on a company's balance sheet as a prepaid expense or a short-term asset. This credit item on the balance sheet must be offset at a future date. In order to reconcile this, the company's accounting department generally inputs a debit by the end of the year to the COGS section.

When underapplied overhead appears on financial statements, it is generally not considered a negative event. Rather, analysts and interested managers look for patterns that may point to changes in the business environment or economic cycle. Should unfavorable variance or outcomes arise—because not enough product was produced to absorb all overhead costs incurred—managers will first look for viable reasons. These may be explained by expected hiccups in production, business, or seasonal variation.

KEY TAKEAWAYS
Underapplied overhead occurs when overhead expenses are more than what a company actually budgets.
This figure reported on a company's balance sheet as a prepaid expense or short-term asset as a credit, then offset by a debit to the cost of goods sold before the end of the fiscal year.
Underapplied overhead is an unfavorable variance because a business goes over budget.
It is generally not considered negative because analysts and managers look for patterns that may point to changes in the business environment or economic cycle.