Underapplied Overhead

Underapplied Overhead (vs. Overapplied Overhead)

Overview

Underapplied overhead occurs when a company’s actual overhead costs exceed the amount it budgeted or applied to production. It is considered an unfavorable variance because the business spent more on indirect costs than planned, which increases the cost of goods sold (COGS) relative to expectations.

How it happens (simple example)

• Budgeted overhead: $100,000
• Actual overhead incurred: $150,000
• Underapplied overhead: $50,000 (actual − budgeted)

This situation can arise from higher-than-expected utility or maintenance costs, lower production volume (so fixed overhead is spread over fewer units), seasonal fluctuations, or other operational disruptions.

Accounting treatment

• Underapplied overhead typically carries a debit balance (reflecting underapplied costs that were not absorbed by production).
• At the end of the accounting period, the balance is usually closed out by charging the remaining underapplied overhead to COGS, which increases COGS and reduces reported gross profit.
• Overapplied overhead (the opposite case, where applied overhead exceeds actual) is closed out in the opposite direction, reducing COGS.

Key formula

Predetermined overhead rate = Budgeted overhead costs ÷ Budgeted activity (e.g., machine hours, labor hours)

This rate is used during the period to apply overhead to products; variance arises when applied overhead (based on the rate and actual activity) differs from actual overhead incurred.

Why it matters

• Monitoring underapplied/overapplied overhead helps identify operational or budgeting issues and informs pricing, cost control, and capital-allocation decisions.
• It is especially important in manufacturing and other production-intensive businesses where overhead absorption affects unit costs and profitability.
• Modern inventory and production systems make it easier to detect patterns in overhead variances and to investigate root causes.

Comparison: Underapplied vs. Overapplied

• Underapplied overhead: actual overhead > applied overhead → unfavorable variance → increases COGS when closed out.
• Overapplied overhead: actual overhead < applied overhead → favorable variance → decreases COGS when closed out.

Takeaways

• Underapplied overhead signals that budgeted overhead was insufficient relative to actual costs or that production volume was lower than expected.
• It is recorded and reconciled at period-end (usually by adjusting COGS) and should prompt investigation into recurring causes.
• Understanding these variances helps managers make better operational, pricing, and capital-allocation decisions.