Budgeted Indirect Costs and End-of-Accounting-Year Adjustments

Learning Objective 7 Adjust for under- or overallocated manufacturing overhead costs at the end of the fiscal year using alternative methods

• for example, writing the amount off to the Cost of Goods Sold account

Managers try to closely approximate actual manufacturing overhead costs and the actual total quantities of the cost-allocation base(s) when calculating the budgeted indirect cost rate(s). However, for the numerator and denominator reasons explained earlier in the chapter, under normal costing, a company’s actual overhead costs incurred each month are likely to not equal its overhead costs allocated each month. Even at the end of the year, total allocated overhead costs are unlikely to equal total actual overhead costs incurred because allocated costs are based on estimates made up to 12 months before actual costs are incurred. For financial accounting purposes, companies are required under Generally Accepted Accounting Principles to report results in the financial statements based on actual costs. We now describe adjustments that accountants need to make when, at the end of the fiscal year, indirect costs allocated differ from actual indirect costs incurred.

Underallocated and Overallocated Indirect Costs

Underallocated indirect costs occur when the allocated amount of indirect costs in an accounting period is less than the actual overhead amount incurred for the period. Overallocated indirect costs occur when the allocated amount of indirect costs in an accounting period is greater than the actual overhead amount incurred for the period.

Underallocated (overallocated) indirect costs are also called underapplied (overapplied) indirect costs and underabsorbed (overabsorbed) indirect costs.

Consider the manufacturing overhead cost pool at Robinson Company. There are two indirect-cost accounts in the general ledger related to manufacturing overhead:

1. Manufacturing Overhead Control, which records the actual costs in all the individual overhead categories (such as indirect materials, indirect manufacturing labor, supervision, engineering, utilities, and plant depreciation).
2. Manufacturing Overhead Allocated, which records the manufacturing overhead allocated to individual jobs on the basis of the budgeted indirect cost rate multiplied by actual direct manufacturing labor-hours.

At the end of the year, the overhead accounts show the following amounts.

The $1,080,000 credit balance in Manufacturing Overhead Allocated results from multiplying the 27,000 actual direct manufacturing labor-hours worked on all jobs in 2020 by the budgeted rate of $40 per direct manufacturing labor-hour.

The $\$\text{135,000\hspace{0.05em}}\ (\$\text{1,215,000}\ \ -\ \$\text{1,080,000})\; \ $ difference (a net debit) is an underallocated amount because actual manufacturing overhead costs incurred are greater than the allocated amount. This difference arises for two reasons related to the computation of the $40 budgeted hourly rate:

1. NUMERATOR REASON (INDIRECT-COST POOL). Actual manufacturing overhead costs of $1,215,000 are greater than the budgeted amount of $1,120,000.
2.  DENOMINATOR REASON (QUANTITY OF ALLOCATION BASE). Total actual direct manufacturing labor-hours of 27,000 are fewer than the budgeted 28,000 hours. 

There are three main approaches to accounting for the $135,000 underallocated manufacturing overhead costs caused by Robinson underestimating manufacturing overhead costs and overestimating the total quantity of the cost-allocation base: (1) adjusted allocation-rate approach, (2) proration approach, and (3) write-off to cost of goods sold approach.