Overhead rates may turn out to be incorrect or out dated because of misjudgments regarding estimated overhead or anticipated activity. A large over or under applied overhead figure does not mean the overhead rates was wrong. Use of a normal rates is purposely designed to show the extent to which normal capacity is or is not used.
Likewise, when an overhead rates based on expected actual conditions is used, seasonal variations may lead to large over or under absorbed overhead which will tend to even itself out during a full year. The best way to detect an incorrect overhead rates is to analyze the factors used in its predetermination. Since a rate is an estimate, small errors should be expected ; and the rate need not be changed for such errors.
CHANGING OVERHEAD RATE
Overhead rates are usually reviewed annually. This procedure helps level out costing through the year and ties overhead control in with budgetary control. If rates are changed during a fiscal or budget period, meaningful comparisons will be difficult. Changes in production methods, prices, efficiencies, and sales expectancy make review and, possibly, revision of overhead rates a necessity at least annually. Revisions should be based on a complete review of all factors involved. The extent to which a company revises its overhead rates depends on frequency of changes, on factors which affect overhead rates and on management’s need and desire for current costs and realistic overhead variance information.
The over or under-applied 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 figure, the computation, analysis, and reporting of both the spending and idle capacity variances are significant and important.