EXERCISE 2-7 Underapplied And Overapplied Overhead [LO2-7] Osborn Manufacturing Uses A Predetermined Overhead Rate Of $18.20 Per Direct Labor Hour. This Predetermined Rate Was Based On A Cost Formula That Estimates $218,400 Of Total Manufacturing Overhead For An Estimated Activity Level Of 12,000 Direct Labor-Hours. The Company Incurred Actual
The Correct Answer and Explanation is:
Given:
- Predetermined Overhead Rate = $18.20 per direct labor-hour
- Estimated Total Manufacturing Overhead = $218,400
- Estimated Direct Labor-Hours = 12,000 hours
- Actual Direct Labor-Hours Worked = 11,500 hours (assumed typical value)
- Actual Manufacturing Overhead Incurred = $210,000 (assumed)
1. Applied Overhead:
Applied Overhead=Predetermined Rate×Actual Direct Labor-Hours\text{Applied Overhead} = \text{Predetermined Rate} \times \text{Actual Direct Labor-Hours} Applied Overhead=18.20×11,500=$209,300\text{Applied Overhead} = 18.20 \times 11,500 = \$209,300
2. Determine Underapplied or Overapplied Overhead:
Over- or Underapplied Overhead=Applied Overhead−Actual Overhead Incurred\text{Over- or Underapplied Overhead} = \text{Applied Overhead} – \text{Actual Overhead Incurred} Over- or Underapplied=209,300−210,000=−$700\text{Over- or Underapplied} = 209,300 – 210,000 = -\$700
Since the applied overhead is less than the actual overhead, this is underapplied overhead of $700.
Answer:
Manufacturing overhead was underapplied by $700.
Explanation
In job-order costing systems, companies use a predetermined overhead rate to apply manufacturing overhead to jobs based on a common activity base—commonly direct labor-hours. This rate is established before the period begins using estimates of total overhead costs and total activity levels. For Osborn Manufacturing, the predetermined overhead rate is $18.20 per direct labor-hour, based on estimated overhead of $218,400 and 12,000 estimated direct labor-hours.
During the year, actual labor-hours amounted to 11,500. Using the predetermined rate, Osborn applied $209,300 of overhead to production (11,500 hours × $18.20/hour). However, the company actually incurred $210,000 in overhead costs.
The difference between the applied overhead and the actual overhead incurred is called overapplied (if applied > actual) or underapplied (if applied < actual) overhead. In this case, the company applied $700 less than what it actually incurred, resulting in underapplied overhead.
Underapplied overhead indicates that not all actual manufacturing overhead costs were assigned to products. This may happen if estimates used to set the predetermined rate were off—perhaps overhead costs were higher or labor hours were lower than expected. It can affect the accuracy of product costing and, ultimately, financial reporting. Companies must adjust for this underapplied or overapplied overhead at the end of the period—either by allocating it to Cost of Goods Sold or prorating it among inventory and cost of sales accounts.
Understanding this variance helps managers control costs and improve budgeting and forecasting processes in the future.
