What is Underapplied Overhead

Underapplied overhead occurs when an accounting record in the cost accounting method includes overhead costs that are assigned to a work-in-progress product does not reach the amount of the actual overhead costs. Underapplied overhead is reported as a prepaid expense on the company's balance sheet and, at the end of the year, it is balanced by inputting a debit to cost of goods sold. Costs of goods sold are the direct cost associated with the production of goods sold by a company. The amount of underapplied overhead is referred to as an unfavorable variance.

BREAKING DOWN Underapplied Overhead

For example, an overhead of $100,000 was incurred, but only $90,000 was applied. This is referred to as an unfavorable variance because it means that the budgeted costs were lower than actual costs and thus the cost of goods sold of the product was more than expected.

The initial predetermined overhead cost rate is calculated by taking the budgeted overhead costs divided by the budgeted activity.

When underapplied overhead appears on financial statements is not generally considered a negative event. Rather, analysts and interested managers will look for patterns which might point to changes in the business environment or economic cycle. Should "unfavorable" variance or outcomes arise because not enough product was produced to absorb all overhead cost incurred, managers will first look for viable reasons, which may be explained by expected hiccups in production, business or seasonal variation.

The Significance of Underapplied Overhead

For certain businesses, such as manufacturing, analysis of underapplied overhead takes on greater significance. Often as part of standard financial planning and analysis (FP&A) activities, careful review on underapplied (and applied) overhead can point to meaningful changes in operational and financial conditions. These can be useful in assessing capital budgeting decisions and the allocation of limited resources from time, money, and human capital.

Advancements in electronic inventory and production management systems have greatly eased the burden of comprehensive operational reporting, often including underapplied overhead analysis. These improvements allow managers to better assess key operational metrics.