Underapplied factory overhead, also known as under-absorbed factory overhead, refers to a situation where the actual overhead costs incurred during a specific accounting period exceed the amount allocated or applied to products or cost objects using the predetermined factory overhead rate. In other words, it represents an underallocation of overhead costs to the products or jobs.
Underapplied factory overhead occurs when the estimated overhead costs used in the predetermined rate calculation are lower than the actual overhead costs incurred. This can happen due to various reasons, such as an increase in the actual level of activity, unexpected changes in cost drivers, or inaccurate estimates used in the predetermined rate calculation.
The underapplied factory overhead is considered as a variance and is typically recorded in the accounting records through an adjusting entry at the end of the accounting period. The entry would debit the Cost of Goods Sold (or an equivalent expense account) and credit the Factory Overhead Control account. By doing so, the underapplied overhead cost is recognized as an expense in the period in which it occurred.
Underapplied factory overhead represents a cost that was not allocated to the products or jobs during the period. It can impact the accuracy of product costs and may result in distorted profitability analysis. Therefore, it’s important for companies to monitor and analyze the underapplied overhead variances, identify the reasons behind the deviation, and take appropriate corrective actions to address the issue.
Conversely, if the allocated overhead costs exceed the actual overhead costs incurred, it is referred to as overapplied factory overhead. In such cases, the overapplied overhead is typically adjusted by making a journal entry that credits Cost of Goods Sold (or equivalent) and debits the Factory Overhead Control account, reducing the impact of the overapplied amount on the financial statements.