When overhead is overapplied or underapplied, there are two different ways to allocated the variance. In the previous post, we allocated all of the variance to cost of goods sold. However, that is not a very accurate way to allocate the variance.
Think back to the calculation of cost of goods sold in our discussion of inventory. There are three different inventory accounts: Raw materials, work-in-progress, and finished goods. If you think back to the calculations for these accounts, overhead was added during the calculation of work-in-progress.
That means that overhead is applied to work-in-progress, finished goods, and cost of goods sold. When the variance is calculated, that variance exists in each of these accounts, not just cost of goods sold. Therefore, in order to make sure that each of these accounts is accurate, the variance should be allocated to each of these accounts.
In order to do this, we need to look at what percentage of the applied overhead is in each of the accounts and allocate the variance based on those percentages.
Let’s look at an example.
K’s Kustom Furniture has applied overhead of $1,300,000. The $1,300,000 is allocated to the following accounts:
Finished goods $150,000
Cost of goods sold $950,000
The balances in the accounts are as follows:
Finished goods $525,000
Cost of goods sold $3,500,000
Actual overhead is $1,450,000
Calculate the amount of the overhead variance and allocate the variance to work-in-progress, finished goods, and cost of goods sold.
We have $1,300,000 in applied overhead currently sitting in the three accounts. We need to determine what percentage of the applied overhead is in each of the accounts. Divide the applied overhead balance in each account by the total amount of applied overhead.
Work-in-progress $200,000 / $1,300,000 = 15.38%
Finished goods $150,000 / $1,300,000 = 11.54%
Cost of goods sold $950,000 / $1,300,000 = 73.08%
Now calculate the variance. We know that overhead is underapplied because the applied overhead is lower than the actual overhead. Not enough overhead has been applied to the accounts. The variance is:
$1,300,000 – $1,450,000 = $150,000 underapplied.
Multiply the $150,000 by each of the percentages.
Work-in-progress $200,000 / $1,300,000 = 15.38% X $150,000 = $23,070 underapplied in work-in-progress
Finished goods $150,000 / $1,300,000 = 11.54% X $150,000 = $17,310 underapplied in finished goods
Cost of goods sold $950,000 / $1,300,000 = 73.08% X $150,000 = $109,620 underapplied in cost of goods sold
We know how much overhead has been underapplied in each account, so we now must adjust each of the account. When overhead is underapplied, there is not enough overhead in each of the accounts. We must add the variance to each of the account balances. Add the variance to the total amount in each account.
Work-in-progress $675,000 + $23,070 variance = $698,070 adjusted Work-in-progress
Finished goods $525,000 + $17,310 variance = $542,310 adjusted Finished goods
Cost of goods sold $3,500,000 + $109,620 = $3,609,620 adjusted Cost of goods sold
When allocating the overhead variance among multiple accounts, look at the amount of applied overhead in each of the accounts: work-in-progress, finished goods, and cost of goods sold. Calculate the percentage of total applied overhead in each of the accounts. Then use that percentage to calculate the amount of the variance that should be allocated to each account. If the overhead is underapplied, add the amount of variance to each of the accounts. If the overhead is overapplied, add the amount of variance to each of the accounts.
Allocating overhead using a predetermined overhead rate
Kristin is a Certified Public Accountant with 15 years of experience working with small business owners in all aspects of business building. In 2006, she obtained her MS in Accounting and Taxation and was diagnosed with Hodgkin's Lymphoma two months later. Instead of focusing on the fear and anger, she started her accounting and consulting firm. In the last 10 years, she has worked with clients all over the country and now sees her diagnosis as an opportunity that opened doors to a fulfilling life. Kristin is also the creator of Accounting In Focus, a website for students taking accounting courses. Since 2014, she has helped over one million students succeed in their accounting classes.