The predetermined overhead rates are used throughout the year to apply overhead to Work in Process Inventory. Overhead may be applied as production occurs, when goods or services are transferred out of Work in Process Inventory, or at the end of each month. Under real-time systems in use today, overhead is frequently applied continuously. “Applied Overhead” is the amount of overhead assigned to Work in Process Inventory as a result of incurring the activity that was used to develop the application rate. Application is made using the predetermined rate(s) and the actual level(s) of activity.
Overhead can be recorded either in separate accounts for actual and applied overhead or in a single account. If actual and applied accounts are separated, the applied account is a contra account to the actual overhead account and is closed against it at year-end. The alternative, more convenient, recordkeeping option is to maintain one general ledger account that is debited for actual overhead costs and credited for applied overhead. This method is used throughout the text.
Additionally, overhead may be recorded in a single overhead account or in separate accounts for the variable and fixed components. Below Figure presents the alternative overhead recording possibilities.
If separate rates are used to apply variable and fixed overhead, the general ledger would most commonly contain separate variable and fixed overhead accounts. When separate accounts are used, mixed costs must be separated into their variable and fixed components or assigned to either the variable or fixed overhead general ledger account. Because overhead costs in an automated factory represent an ever larger part of product cost, the benefits of separating costs according to their behavior are thought to be greater than the time and effort expended to make that separation.
Regardless of the number (combined or separate) or type (plant wide or departmental) of predetermined overhead rates used, actual overhead costs are debited to the appropriate overhead general ledger account(s) and credited to the various sources of overhead costs. Applied overhead is debited to Work in Process Inventory and credited to the overhead general ledger account(s). Actual activity causes actual overhead costs to be incurred and overhead to be applied to Work in Process Inventory. Thus, actual and applied overhead costs are both related to actual activity, and only by actual activity are they related to each other.
Assume that during March 2008, the Waxing and Polishing Department incurs 5,000 machine hours. Actual variable and fixed overhead costs for the month were $10,400 and $7,300, respectively. Assume also that applied variable overhead for March is $10,000 (5,000 x $2.00) and applied fixed overhead is $7,150 (5,000 x $1.43). The journal entries to record actual and applied overhead for March 2008 are:
[Debit]. Variable Manufacturing Overhead = $10,400
[Debit]. Fixed Manufacturing Overhead = $7,300
[Credit]. Various Accounts = $17,700
(To record actual manufacturing overhead)
[Debit]. Work in Process Inventory = $17,150
[Credit]. Variable Manufacturing Overhead = $10,000
[Credit]. Fixed Manufacturing Overhead = $7,150
(To apply variable and fixed manufacturing overhead to WIP)
At year-end, actual overhead will differ from applied overhead and the difference is referred to as under-applied or over-applied overhead. “Under-applied overhead” means that the overhead applied to Work in Process Inventory is less than actual overhead; “over-applied overhead” means that the overhead applied to Work in Process Inventory is greater than actual overhead. Under-applied or over-applied overhead must be closed at year-end because a single year’s activity level was used to determine the overhead rate(s). Learn “Disposition Of Underapplied and Overapplied Overhead Cost” on my next post.