What is Underapplied Overhead?
687 reads · Last updated: December 5, 2024
The term underapplied overhead refers to a situation that arises when overhead expenses amount to more than what a company actually budgets for in order to run its operations. Underapplied overhead is normally reported as a prepaid expense on a company's balance sheet and is balanced by inputting a debit to the cost of goods sold (COGS) section by the end of the year. 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.
Definition
Unallocated overhead refers to the situation where a company's actual indirect expenses exceed the budgeted amount. It is typically reported as a prepaid expense on the company's balance sheet and balanced at year-end by debiting the cost of goods sold. The amount of unallocated overhead is known as an unfavorable variance.
Origin
The concept of unallocated overhead originates from budget control practices in corporate financial management. As companies grow and financial management becomes more complex, there is a need for more precise control over indirect expenses to ensure financial health and profitability.
Categories and Features
Unallocated overhead can be categorized into two main types: fixed indirect expenses and variable indirect expenses. Fixed indirect expenses do not change with production levels, such as rent and salaries of administrative staff. Variable indirect expenses vary with production levels, such as production materials and energy consumption. The key feature of unallocated overhead is its unfavorable variance, which typically requires budget adjustments or efficiency improvements to address.
Case Studies
Case Study 1: A manufacturing company in 2023 found its indirect expenses exceeded the budget by 10%. Analysis revealed that the main cause was rising energy prices. The company reduced unallocated overhead by improving production efficiency and optimizing energy use. Case Study 2: A retail company in 2024 experienced increased unallocated overhead due to rising rent costs. The company reduced costs by renegotiating leases and optimizing store layouts.
Common Issues
Common issues investors face include identifying the sources of unallocated overhead and effectively managing these unfavorable variances. It is generally recommended that companies regularly review budgets and actual expenditures and adjust strategies promptly to reduce unfavorable variances.
