Determine whether there is over or under applied overhead.
Prepare the journal entry to allocate (close) over applied or under applied overhead to Cost of Goods Sold.
The following information is available for Lock-Tite Company, which produces special-order security products and uses a job order costing system.
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Determine whether there is over or under applied overhead.
Record entry to allocate (close) under-applied/over-applied overhead to cost of goods sold.
The Correct Answer and Explanation is :
To determine whether there is over-applied or under-applied overhead, we need to calculate the applied overhead and compare it to the actual overhead incurred.
Step 1: Calculate Applied Overhead
The applied overhead is the overhead that has been allocated to the jobs during the period based on a predetermined overhead rate. The formula for applied overhead is:
[
\text{Applied Overhead} = \text{Predetermined Overhead Rate} \times \text{Actual Activity Level}
]
The predetermined overhead rate is usually calculated at the beginning of the year based on estimated overhead and the expected activity level.
Step 2: Compare Applied Overhead to Actual Overhead
After calculating the applied overhead, compare it to the actual overhead incurred during the period. The difference between these two will tell us whether the overhead was over-applied or under-applied:
- Over-applied overhead: If the applied overhead is more than the actual overhead, the company has over-applied its overhead.
- Under-applied overhead: If the applied overhead is less than the actual overhead, the company has under-applied its overhead.
Step 3: Journal Entry to Close Over-Applied or Under-Applied Overhead
Once you have determined whether there is over-applied or under-applied overhead, you will close the overhead account to the Cost of Goods Sold (COGS).
- If over-applied overhead exists, you will decrease the Cost of Goods Sold.
- If under-applied overhead exists, you will increase the Cost of Goods Sold.
Example Journal Entries:
- Over-Applied Overhead:
- Debit: Overhead (for the amount over-applied)
- Credit: Cost of Goods Sold (for the amount over-applied)
- Under-Applied Overhead:
- Debit: Cost of Goods Sold (for the amount under-applied)
- Credit: Overhead (for the amount under-applied)
Explanation:
When a company uses job order costing, overhead is applied to jobs based on a predetermined rate. This rate is typically calculated at the beginning of the year based on estimated overhead and expected activity levels (like machine hours or labor hours). However, at the end of the period, the actual overhead incurred can differ from the applied overhead. This discrepancy is known as “over-applied” or “under-applied” overhead.
- Over-applied overhead means that the company applied more overhead to its jobs than it actually incurred. This could happen if the actual activity level was lower than expected or if actual overhead costs were less than estimated. In this case, the company would have charged too much overhead to its jobs, so it needs to reduce the overhead in the accounts.
- Under-applied overhead means that the company applied less overhead to its jobs than was actually incurred. This could happen if the actual activity level was higher than expected or if actual overhead costs were more than estimated. In this case, the company would need to increase the overhead applied to jobs to reflect the actual costs.
By adjusting the overhead account at the end of the period, companies ensure that their Cost of Goods Sold reflects the true cost of producing goods during the period.
Would you like to provide more specific numbers so I can help you work through a calculation for the over-applied or under-applied overhead?