Budget overhead: underapplied or overapplied?

What does underapplied overhead mean?

Underapplied overhead is when a company’s operating costs are more than what it has budgeted for. Underapplied overhead is usually shown as a prepaid expense on a company’s balance sheet, and by the end of the year, it is balanced by adding a debit to the cost of goods sold (COGS) section. Costs of goods sold are the direct costs that a company has to pay to make the goods it sells. An unfavourable variance is the amount of overhead that wasn’t used enough.

KEY TAKEAWAYS

• Underapplied overhead is when a company’s expense costs are higher than what it has planned for in its budget.
• This number is listed as a debit on a company’s balance sheet as a prepaid expense or short-term asset. It is then offset by a debit to the cost of goods sold before the end of the fiscal year and a credit to prepaid expenses.
• Underapplied overhead is an unfavourable variance because it causes a business to go over budget.
• Analysts and managers look for patterns that could point to changes in the business environment or economic cycle, so this is not usually seen as a bad thing.

Getting to know about underapplied overhead

Before we look at how underapplied overhead works, we need to define what expense costs are. The costs that come with running a business are known as “overhead.” More specifically, these are costs that a business has to pay every day but that don’t have anything to do with making a product or service. Businesses need to know their overhead costs for a number of reasons, such as budgeting and figuring out how much to charge customers to make a profit.

When a business doesn’t set aside enough money for its overhead costs, this is called “underapplied overhead.” This means that the amount planned in the budget is less than what the business actually spends to run. For example, if a company spends $150,000 on expense costs but only planned to spend $100,000, it has $50,000 in underapplied overhead. This is called an unfavourable variance because it means that the costs in the budget were lower than the costs in the real world. Simply put, the business spent more than it had planned, so the cost of goods sold was higher than expected.

As was said above, a company’s balance sheet shows underapplied overhead as a prepaid expense or a short-term asset. This debit on the balance sheet needs to be made up for at some point in the future. To fix this, the accounting department of the company usually puts a debit in the COGS section and a credit in the prepaid expenses section by the end of the year.

When underapplied overhead shows up on a company’s financial statements, it’s usually not seen as a bad thing. Instead, analysts and interested managers look for patterns that could point to changes in the business environment or economic cycle. If there are unfavourable changes or results, like not enough product being made to cover all of the expense costs, managers will first look for good reasons. These things could be caused by expected bumps in production, business, or the seasons.

Things to think about

Some businesses, like manufacturing, need to pay more attention to how they use their expense costs. As part of normal financial planning and analysis (FP&A) tasks, a careful look at underutilised overhead costs can often point to important changes in operational and financial conditions. These can help you decide how to spend your limited time, money, and human capital. They can also help you make decisions about your capital budget.

Electronic inventory and production management systems have made it much easier to do detailed operational reporting, which often includes analysis of costs that aren’t being used. With these changes, managers will be able to evaluate key operational metrics better.

Too little overhead vs. too much overhead

The opposite of using too much overhead is using too little overhead. Overused overhead happens when a company’s actual costs are less than what it planned for in its budget. This means that during the accounting period, a company comes in under budget and spends less on overhead costs.

Businesses must also take into account costs that are used too much. This is recorded on the balance sheet the opposite way that underapplied overhead is—first as a credit to the expense section, which is then cancelled out by a credit to the COGS section and a debit to the overhead section by the end of the fiscal year.

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