Adjusting Over-applied Overhead, Reasons, Importance, Methods, Example

Over applied overhead happens when the overhead applied to production is more than the actual overhead spent by the business. This means the predetermined rate applied a higher amount of overhead than what the business actually used. For example, if the actual overhead cost is rupees ten lakh but the applied overhead is rupees eleven lakh, then the overhead is over applied by rupees one lakh. It shows that the business charged more overhead to products than necessary. In simple words, production was burdened with extra overhead.

Over applied overhead usually occurs when actual production is more than expected or when the business spends less overhead than estimated. It may also occur when the predetermined rate was set too high. Over applied overhead is considered a favourable situation because the actual spending is lower than expected. However, it still needs to be adjusted to show correct product cost.

Reasons for Over Applied Overhead:

• Actual Overhead Cost is Lower than Estimated

Over applied overhead happens when the actual factory overhead spent during production is less than what was estimated at the beginning of the period. Companies use a predetermined overhead rate based on estimated costs. If the actual expenses such as power, repairs, indirect materials, or supervision cost less than planned, the applied overhead becomes higher. This difference creates over application, showing that the organisation spent less on overhead than expected during the period.

• Actual Production Level is Higher than Estimated

When actual units produced or actual labour hours used are more than the estimated level, more overhead is applied to jobs. The predetermined overhead rate multiplies actual activity to calculate applied overhead. If the activity level is higher than planned, the applied overhead increases automatically. Even if actual overhead cost remains the same, the applied amount becomes higher. This leads to over applied overhead because the system assumes more cost should be assigned due to increased production.

• Efficient Control Over Overhead Expenses

If the company successfully controls overhead expenses through better management, over applied overhead may occur. For example, cost-saving measures like reducing wastage, improving energy use, controlling indirect materials, or efficient supervision reduce actual overhead. When actual cost decreases due to good cost control but the predetermined rate is based on older and higher estimates, the applied overhead becomes more than the actual amount. This creates a favourable variance known as over applied overhead.

• Sudden Drop in Indirect Expenses

Sometimes certain indirect expenses reduce suddenly, which leads to lower actual overhead costs. Examples include reduced electricity tariffs, lower fuel prices, fewer machine breakdowns, or temporary reduction in indirect labour. These changes decrease actual spending. However, the predetermined overhead rate does not change during the period. So applied overhead calculated using estimated data becomes higher than actual overhead, resulting in over applied overhead.

• Seasonal or Cyclical Variations

In many industries, production activities increase during some months and stay low during others. If production rises sharply during the period, more overhead gets applied because of higher machine hours or labour hours. However, actual overhead cost might not increase at the same speed. Due to this mismatch between actual overhead and applied overhead, the applied amount becomes higher. This is common in seasonal industries, where estimates set at the beginning do not match actual activity during peak season.

• Use of Outdated or Inaccurate Estimates

If the predetermined overhead rate was calculated using old or inaccurate estimates, the applied overhead may exceed actual overhead. For example, a company may estimate higher indirect labour or higher power cost based on last year’s data, but current-year overhead is lower. Since the rate is fixed in advance, it may not reflect actual conditions. This difference between outdated estimates and current reality generates over applied overhead by the end of the accounting period.

Importance of Adjusting Over Applied Overhead:

• Ensures Correct Cost of Production

Adjusting over applied overhead is important because it brings the cost of production to the correct and realistic level. If the over applied amount is not removed, the cost of jobs or products will appear higher than the actual cost. This creates confusion while analysing performance. By adjusting the extra overhead, the accounts show only the true manufacturing cost. This helps managers, accountants, and auditors rely on accurate cost information for decision making and financial reporting.

• Helps in Accurate Profit Measurement

If over applied overhead is not adjusted, profits will appear higher than the true profit. The cost is reduced artificially due to extra applied overhead, which inflates profit. By adjusting over applied overhead, we correct the income figure and show the real profit earned by the company. This is important for managers, owners, tax authorities, banks and all stakeholders who depend on accurate profit measurement. Proper adjustment ensures that financial statements show a fair and honest picture of business performance.

• Improves Budgeting and Cost Planning

Adjusting over applied overhead provides valuable information for future budgeting and cost planning. It shows whether the company overestimated expenses or production activities. When accountants analyse the adjusted overhead variance, they understand where estimates were wrong and how they can prepare better budgets for the next year. This helps businesses plan overhead costs more accurately and avoid large differences between expected and actual costs. Correct budgeting supports better control over indirect expenses in the long run.

• Supports Effective Cost Control

Over applied overhead indicates that actual overhead costs were lower than expected. Adjusting this difference helps managers study the reason behind this favourable variance. They can identify cost-saving areas like improved supervision, better energy efficiency or reduced wastage. This helps the management continue positive practices and maintain cost control in future. Without proper adjustment, these insights may be ignored. Adjusting the overhead variance also helps in comparing departments and activities accurately for improving operational efficiency.

• Ensures Fair Valuation of Inventory

Inventory valuation depends on correct manufacturing cost. If over applied overhead is not adjusted, the cost assigned to finished goods and work in progress becomes inaccurate. This can lead to overvalued or undervalued inventory figures. Adjusting the over applied overhead ensures that only actual overhead is included in inventory cost. This provides a fair valuation for financial statements and helps the business maintain compliance with accounting standards. Accurate inventory valuation protects business credibility and improves decision making.

Methods of Adjusting Over Applied Overhead:

1. Transfer Entire Amount to Cost of Goods Sold (COGS)

In this method, the full over applied overhead is transferred to the Cost of Goods Sold account. It is used when most of the production for the period has already been sold. By transferring the extra applied overhead to COGS, the cost is reduced and profit becomes accurate. This method is simple and quick because only one account is adjusted. It ensures that the income statement shows the correct cost and real profit. This method is suitable for small organisations or when the difference is small.

2. Allocate Over Applied Overhead to WIP, Finished Goods and COGS

In this method, the over applied overhead is divided among Work in Process, Finished Goods and Cost of Goods Sold. The allocation is done based on the proportion of overhead each account carries. This method is used when some goods are still in process and some are completed but not sold. It gives more accurate results because all inventory accounts are corrected. This method is suitable for large organisations where inventory values are significant. It ensures fair valuation of all stock items.

3. Adjust Through the Overhead Control Account

This method adjusts the over applied overhead directly in the overhead control account. When the accounting period ends, the balance in the overhead control account is transferred to the appropriate accounts. If overhead is over applied, the control account will show a credit balance. This balance is closed by transferring it to Cost of Goods Sold or by distributing it to inventory accounts. This method provides transparency because it shows clearly whether overhead was over or under applied and helps in better cost analysis.

Effect of Over Applied Overhead Adjustment:

• Corrects Product and Job Costing

Adjusting over applied overhead corrects the cost assigned to jobs, products and processes. When extra overhead is applied, product cost becomes artificially high. After adjustment, only the actual overhead remains in the cost records. This gives the true cost of production and helps managers understand the real expense of each job. It also improves decision making for pricing, quotations and cost comparisons. Correct product costing prevents mistakes in estimating future costs and ensures that the business remains competitive in the market.

• Ensures Accurate Profit Reporting

Over applied overhead reduces the cost shown in Cost of Goods Sold, which increases profit artificially. When this extra overhead is adjusted, the profit figure becomes accurate. This is important for financial reporting, tax filing, loan applications and performance analysis. Correct profit measurement helps management understand the real financial health of the business. It also creates trust among investors and other stakeholders. Without this adjustment, financial statements may mislead users and affect important decisions about operations and investments.

• Improves Inventory Valuation

Inventory includes Work in Process and Finished Goods. If over applied overhead is not adjusted, these inventories will show higher cost than the actual amount. By adjusting the extra overhead, the value of inventory becomes accurate. This ensures that the balance sheet shows the correct closing stock value. Proper valuation helps the business follow accounting standards and avoids issues during audits. Accurate inventory values also support better control over stock, reduce wastage and help in deciding reorder levels in future.

• Helps Identify Cost Variances

When over applied overhead is adjusted, managers can clearly see the variance between estimated overhead and actual overhead. This helps them understand why the variance occurred, whether it is due to wrong estimates, higher production levels or better cost control. Identifying these reasons helps improve future budgets and internal controls. It also supports performance evaluation of departments. By analysing the variance after adjustment, management can take corrective steps to avoid similar issues in future periods.

• Enhances Reliability of Financial Statements

Financial statements become more reliable when over applied overhead is adjusted properly. Users of financial statements, such as owners, banks and auditors, expect accurate information. If overhead is not adjusted, the statements may show incorrect costs, inventory and profit. After adjustment, the reports present a fair and honest view of business performance. This improves the credibility of the company and builds trust with external parties. Reliable statements also help in planning, forecasting and assessing long term growth.

Example of Over Applied Overhead Adjustment:

Estimated factory overhead for the year: ₹4,00,000

Estimated labour hours: 20,000

Predetermined overhead rate: ₹20 per hour

Actual labour hours used: 21,000

Applied overhead: 21,000 × ₹20 = ₹4,20,000

Actual overhead incurred: ₹3,95,000

Over applied overhead = ₹4,20,000 minus ₹3,95,000 = ₹25,000

This ₹25,000 must be adjusted.

METHOD 1: Transfer Entire Over Applied Overhead to Cost of Goods Sold

Used when most goods are sold and inventory is small.

Journal Entry Table

METHOD 2: Allocate Over Applied Overhead to WIP, Finished Goods and COGS

Used when inventory has significant balances.

Assume Closing Balances Before Adjustment

Work in Process (WIP): ₹1,00,000

Finished Goods: ₹2,00,000

Cost of Goods Sold (COGS): ₹7,00,000

Total: ₹10,00,000

Step 1: Find allocation ratio

WIP share = 1,00,000 ÷ 10,00,000 = 10 percent

Finished Goods share = 2,00,000 ÷ 10,00,000 = 20 percent

COGS share = 7,00,000 ÷ 10,00,000 = 70 percent

Step 2: Allocate ₹25,000 Over Applied Overhead

WIP = 10 percent of 25,000 = ₹2,500

Finished Goods = 20 percent of 25,000 = ₹5,000

COGS = 70 percent of 25,000 = ₹17,500

Journal Entry Table