How Are Over or Underapplied Overhead Treated

Disposition of Over or Underapplied Overhead: Because of its importance, the analysis of the over or underapplied overhead figure is presented in detail. Disposition of this figure is generally quite simple. Although total over or underapplied overhead is analyzed into spending and idle capacity variances, it need not be Journalized and posted in two parts.

Treatment for Over or Underapplied Overhead:

At the end of the fiscal period, overhead variances may be treated as:

  1. a period cost,
  2. divided between inventories and cost of goods sold, especially if the rate appears to have been in error, or
  3. treated as period cost but divided between inventory and cost of goods sold if a gain or favorable depending on the nature of the variance.

Current Internal Revenue Service regulations require inclusion in inventories of an allocated portion of significant annual overhead variances. Where the amount involved is not significant, in relation to total actual factory overhead, an allocation is not required unless such allocation is made for financial reporting purposes. Also the taxpayer must treat over or underapplied overhead consistently. The regulation, however, do permit expending of the idle capacity variance.

For financial reporting purposes, two procedures that are used for closing over or underapplied overhead are: (l) close to cost of goods sold or (2) close directly to Income Summary, thereby treating the over or under-applied overhead as a period cost. The entries are:

Cost of Goods Sold        7,000

Factory Overhead Control      7,000


Income Summary     7,000

Factory Overhead Control    7,000

The over or underapplied overhead figure is closed to the cost of goods sold account or to the income summary account depending on whether management considers such a variation a manufacturing or managerial cost.

If the variance is closed to the cost of goods sold account, it will appear in the cost of goods sold statement. If it is closed to the income summary account, it will appear in the income statement. Regardless of the disposition made of the over or under-applied overhead figure, the computation, analysis, and reporting of both the spending and idle capacity variances are significant and important.

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