Underallocated Overhead Occurs When Least Expected – Here Is What You Need to Know

Accounting, financing, investing… All these things have many concepts in common, and while many principles make common sense, some others require a bit of education. For example, most people have no clue that underallocated overhead occurs when you spend more than what you plan.

In theory, the idea is fairly simple to understand – there is nothing to be concerned about. However, as you dig deeper, you realize this concept goes way further than that. In fact, it can make things quite complicated too.

Generally speaking, applied overheads represent the total of actual overhead costs that are not normally allocated in the first place. Basically, whatever you planned for the production does not work, and you end up spending more, whether it is an error, something you missed, or perhaps prices going up.

Understanding the concept of underallocated overhead​

Underallocated overhead occurs when the general allocation amount of money for your production does not match the actual costs. It is determined over a specific period of time – normally, over different reporting periods.

The actual allocation is not used – instead, a standard allocation comes into play. It happens when the people running the company try to achieve consistency in applying the exact same costs to production units over a year.

The standard allocation is normally given based on statistics or history. It is based on the overhead incurred in the past. Obviously, things change, so there will be slight adjustments here and there for the next reporting period.

Expectations are often exceeded and not always in a good way. When you have an underallocated overhead, things are going the wrong way. Your expectations have been exceeded in terms of costs. So, how does it work?

Imagine allocating $100,000 of factory overhead for your production. But then, there is an under application of $50,000. This means the total cost of the production was $150,000, rather than what you allocated in the first place.

Most commonly, this overhead is reported as prepaid expenses when you do the balance sheet of the company. It balances out by adding a debit to the overall costs of products sold – or perhaps services offered. You do the math at the end of the year.

Based on what it means, the underallocated overhead is a negative balance for your business. It can affect the profits, and if it is too much over your allocated amount, you even risk losing money – a serious mistake can literally kill a business.

No matter what goods you sell or what products you offer, you practically go over your budget. If you are lucky, you might be able to get things fixed before it is too late. If you are unlucky, you may not even be able to complete the operations if your budget is not generous enough.

Now, while it is normally considered a negative thing, many managers see it as an unfavorable situation and nothing else. They try to find patterns and identify their mistakes while getting ready for the next economic cycle.

How the underallocated overhead actually works​

It is essential to understand all the costs associated with the business before figuring out how the underallocated overhead works. When you think of the business overhead, you practically define all the costs needed to run the business accordingly.

These expenses do not count major acquisitions, but the specific costs to run a business on a daily basis. Obviously, different businesses can see things in different ways. For instance, underallocated overhead occurs when the production exceeds expectations in terms of costs.

But at the same time, some may take the underallocated overhead for day by day operations. All in all, the overhead is extremely important for a company because it can determine the necessity for budgeting, not to mention sale prices to actually make a profit.

The underapplied overhead occurs when the company fails to budget responsibly for its overhead costs. The management sets up a limit, but the business needs more than that to run accordingly. The excess is the actual underapplied overhead.

You budget $50,000, and you spend $70,000 – that means the underapplied overhead is $20,000.

The unfavorable situation means you need to pull more money out of your pocket to cover the expenses. You go over budget, making the production more expensive. The profit is clearly affected, and you might as well need to increase the selling price.

Again, the underapplied overhead is most commonly reported in the balance sheet as a temporary asset or perhaps a prepaid cost. You will have to offset it at some point in the future. It is normally the accountant’s job – basically, they need to input the debit before the year is over.

Normally, the underapplied overhead showing on a statement means something is wrong. Sure, if an unexpected growth kicks in, the profits are directly proportional, and in this case, it may not necessarily be a bad thing.

Even when it is simply a calculation mistake, lots of people do not see it as something negative. Instead, they see it as the opportunity to improve – find a pattern, identify a mistake and become much better in the future.

The reason behind the underallocated overhead is the factor that determines whether you have something to learn or you need to make some corrections. For example, if you fail to produce enough to absorb all the costs, you will have to find the reason.

Sometimes, it is just part of the game – seasonal variation or the weather. As for the initial calculation, you determine the overhead cost by dividing the budgeted overhead by the budgeted activity – it is just a simple number.

Specific considerations when dealing with the underallocated overhead​

The underallocated overhead is often overlooked in small businesses. Managers simply try to allocate more funds for the next year or increase prices a bit. They do not conduct proper analysis to determine the causes. Large companies take it more seriously, however, massive income can cover this issue.

Certain industries can seriously benefit from this amount. In fact, it represents a significant consideration for those in the manufacturing industry. An unexpected value in the overhead may change everything – from financial planning and analyses to updates in the financial conditions and operations.

The number will affect capital decisions, budgeting, time, and human capital altogether.

The good news is that compared to a few decades ago, the underallocated overhead is a less common problem. As time goes by, more and more business owners rely on modern tools and applications to reduce risk and unexpected situations.

More and more businesses – even small ones – rely on electronic inventories. They have production management applications to make operational reporting less complicated and more up-to-date. Everything can be done in real time, including the overhead analysis.

Such improvements allow the management to assess the situation in a more efficient manner.

Moving on, the underallocated overhead occurs when expenses are often missed too. New managers and business owners may not necessarily be familiar with all the costs – especially since there are many unexpected situations too.

All these expenses refer to the amount of money needed by the company to run by the book. Each operation will incur a cost, so everything must be covered. Keep in mind that there is a difference between capital expenditures and expenses.

Expenses are actually meant to bring in some benefits for the company. Their role is to provide some advantages over a specific period of time. On the other hand, capital expenditures provide benefits over multiple time periods.

The overhead is an actual expense. It is needed to handle the operations of the company, but it is not normally associated with specific services or products. Becoming familiar with all the costs is a must, and here are some of the most important ones.

The price of sold products and functionality expenses​

This is probably the main consideration in the process. These two major expenses represent the most important thing and will account for most of the costs. The cost of sold products represents all the money you spend in order to purchase goods and sell them further on.

Such goods are used for the overall functionality of the business. The same rule applies to goods purchased in order to offer service over a particular time frame. Most business managers rely on these costs to estimate the overhead.

On the other hand, operating expenses are just as important and will also account for a decent chunk of money. This category accounts for all the money spent to run the business – all the money needed to sell the products, as well as all the money needed to run the business.

These expenses may vary based on the industry and field you activate in.

While overhead may include all the operating costs, the truth is that manufacturing overhead goes in a completely different category. It relates to the costs of products sold. The total amount of overhead will not be affected, though.

Manufacturing overhead explained in small details​

The manufacturing overhead represents another major consideration that will add to the total cost. This specific category covers all the expenses of products sold that cannot go into other categories. Such costs are more general and will not be associated with particular products or services in the manufacturing part.

In other words, this category will most likely include all sorts of disparate stuff. Utilities, for instance, go in this group of expenses. All the money needed to run the production procedures – from bills to maintenance – will go into the manufacturing overhead too.

At this point, it is worth mentioning both the underapplied and overapplied manufacturing overhead. Any of these situations can arise if the budgeted overhead is different from the total manufacturing overhead – there is obviously a discrepancy there.

Underapplied overhead and the application on financial statements​

When you count prepaid expenses, they usually go as assets on the final balance sheet. To help you understand this concept, imagine having $20,000 in underapplied overhead records. That particular amount of money will become a prepaid expense in accounting terms.

Now, what happens at the end of the time frame? The business getting some underallocated overhead will obviously have higher expenses. The income statement will mention this. As a direct consequence, the net income over that specific period of time will be reduced.

At this point, there are two options. You can decide to record the whole amount of money, but you can also record a specific part of it. It depends on more factors. Most importantly, you need to decide if you want to allocate the underallocated overhead to the price of products sold, work, or finished goods.

From some points of view, it makes no difference what option you choose. The underallocated overhead will have an impact on your financial statement, and it will not really make a difference in the long run, but mostly over a specific period of time.

The importance of applied overhead​

The applied overhead is extremely important, despite being ignored by numerous small business owners. It makes no difference if it is an overallocated overhead or an underallocated overhead. Its importance is critical.

Cost ascertainment is probably the most important reason wherefore you need to get these things done. This is the critical aspect that makes the applied overhead such an important asset. It gives you a bigger image over your business.

You just cannot run a company without really knowing what goes in and out. Sure, it might work, but you will lose huge amounts of money in the short or long run. It is just like going into business without an actual plan.

Apart from cost ascertainment, the applied overhead will also help you make more informed and efficient decisions regarding the business. These numbers give you the possibility to make managerial decisions in the right direction.

At the end of the day, the whole cost of the product is ascertained. The applied overhead cost is also counted. You can make better pricing decision, but you can also determine whether or not the production is worth the money and effort.

Last, but not least, think about the financial reporting purpose as well. Having some numbers and figures will help you allocate money in a more efficient manner. You will be aware of all the expenses and potential unexpected situations.

A top-notch classification of overheads, you will improve your financial reporting. If you think about it, the overhead expenses are actually responsible for the balance sheet, not to mention the final income statement.

Benefits of considering the allocated overhead​

Some overhead costs cannot really go into certain categories. They simply cannot be assigned to one object or another, despite the cost. Take rent, for example. Think about the required insurance policies as well. The list is longer and may also include the staff compensation.

All these things become part of the applied overhead. They are not necessarily needed by activities that can impact your decision-making capability. They are usually fixed and less likely to change too much overtime.

With all these, they are still important. Their primary role is to help your accountant. It is not all about accounting presentations and purposes though. A good accountant can play around with them and even save you money in terms of taxation.

It is worth mentioning things that make common sense as well. The overhead will allow you to make better plans for the future. You know what your expenses are, so you can direct money in a more efficient manner.

The overhead cost is normally added when the cost becomes a reality and the businesses incurs it. Simply put, the business will find it difficult to ascertain the real expense of a particular project until the cost becomes a reality.

Having all this data will help managers make more accurate estimates in the future. If you dive in without any data at all, guesswork becomes the norm. Unexpected situations will be more common than ever, ruining the business sooner than later.

Now, overhead costs may experience all kinds of fluctuations – it makes perfect sense. Think about seasonal variations, for example. Some costs tend to go higher during the wintertime, but the summer months are quite low. It depends on the industry, product, and service you deal with.

Being aware of the overhead means seasonal variations will be successfully tackled. You know, for example, that swimming suit sales will drop once the fall season kicks in, so you can estimate costs accordingly.

Being able to price decision is not the only benefit. As a manager, your decisions regarding capital management will stand out. You have the numbers, you know what goes where and you know what to do next – simple as that. In the long run, having all this data will add to the overall profits.

Underapplied overhead versus overapplied overhead​

The operating principles are pretty much the same, only they go in different directions. The underallocated overhead is basically the opposite of overallocated overhead. The overallocated overhead kicks in when the expenses you predict are way less than what you had in mind.

To keep it simple, you make some estimations upfront. You try to ensure there will be no unexpected surprises. However, there will still be plenty of fluctuations here and there. Sometimes, they work in your favor.

In theory, it looks like the overapplied overhead is a great thing. You estimate your costs to be higher than they are, so unexpected situations are less likely to affect you too much. However, from a professional point of view, this is not always a good idea. Why not? Simple.

If you allocate too much money for expenses that never occur, chances are you will need to put more money into things that really matter – such as growing the business, expanding the inventory, hiring more staff, and so on.

Again, while the underallocated overhead may seem bad, it is also helpful to educate managers and show them what needs to be done next. These concepts can be positive or negative, but the truth is managers try to gain the best out of them.

The overall idea is fairly simple to understand. Allocating too much money is not a good idea, while allocating too little money can expose you to financial risks. The point? Try to find a balance between them and ensure the overhead matches the actual expenses.

This is why you need this overhead. This is why you need to know how your company is doing or what kind of money it requires to run. Guesswork will never really work, and you should never make financial decisions based on luck.

It is also important to know that the overhead can go in more directions. Different companies and industries have different rules. Overall, the purpose is pretty much the same, but there are small specifications that make things different.

For example, the administrative overhead is not linked to the production of goods or services. Instead, these expenses are indirect and may include employee costs, legal fees, utility bills, audit fees, and the list can continue.

The absorbed overhead covers all the money required for the manufacturing overhead. It is taken into consideration by using predetermined amounts. How about the factory overhead? It is also known as manufacturing overhead and covers expenses associated with the operation running.

Direct costs are not included – materials, labor, and so on.

Conclusion​

As a short final conclusion, there are plenty of overhead considerations out there, and they may vary widely from one company to another. The overhead is often overlooked in small businesses, yet it can build the path to a steady growth – it is more common in large companies though.

The underallocated overhead occurs when you estimate less expenses than what you actually have, and while it might be a bad idea to do so, the data can also help you identify trends and patterns in your expenses. In the long run, it will help you make more efficient decisions regarding your business.

 

[fanban]

Good guide for beginners running a business, online or offline doesn't matter.

 

[lory]

another yet good article for all of you who started a offshore company or plan to do so. Regardless if it is offshore or onshore, if you don't have a clue on how to run a company, you should grab your coffee and read!