 Hello and welcome to this session. This is Professor Farhad in which we will discuss over applied and under applied overhead. Now it's very important to see the big picture and what is the big picture? The big picture is this, we have basically three cost, three types of cost, material, labor and under material we're going to have direct and indirect let's say we have direct material, direct labor and anything that's not direct material and direct labor is manufacturing overhead. So this is the account that we're going to be dealing with. So the manufacturing overhead account for everything that's not direct material and not direct labor in a manufacturing environment. Simply put, let's take a look at it. I'm just going to call this account overhead. Now the overhead account, it's going to have a debit side and a credit side. On the debit side, we are going to keep track of the actual overhead what actually incurred. Then at some point, we're going to apply, we're going to transfer the overhead from the overhead account to work in process. So eventually we're going to have to credit the overhead account and debit work in process which we saw this in the prior session using a predetermined overhead rate. And this is what we are dealing with here. So this is the applied or the estimated, what we estimated based on the predetermined overhead rate. Now actual and applied will not be the same. There's going to be a difference between actual and applied. Sometime we're going to have over applied or under applied. So we need to know the difference between those two accounts. So what is over applied and under applied? It's the difference between two things. The amount of overhead cost applied, which is the estimated amount. And how do we estimate this using a predetermined overhead rate and the actual overhead cost? The difference between those two is either under applied or over applied. When do we have it under applied? When do we have it over applied? Let's start with under applied. Under applied exist when the amount of overhead estimated. So let's go back here and have a T account for overhead just kind of to see this. We said this is the actual and this is the applied. I'm going to show you this T account several times because once you understand that you're good to go. So under applied overhead exist when the amount of overhead applied, this amount here, let's assume this is $100 is less than the actual, than the total, than the total amount of overhead actually incurred. So it's less. So actual is $120. So if we actually incurred $120 in overhead, but based on our predetermined overhead rate, we applied, we transferred $100 to work in process to work in process. What happened is this, we underestimated because the actual was higher. This is the under what happened when we overestimate. So if we have an overhead account here, again, we have, again, I'm going to keep writing this because it's going to make your life easy once and for all understanding this difference. Now what's going to happen is this, now it's the opposite. When the over, sorry, what happened is this, when the overhead is greater, the overhead applied the greater. So this is $100 and this is $80. Now what we did is we over applied, overestimated because the actual was $80, what we end up doing is applying estimate, applying to work in process, applying to work in process $100, but we actually incurred $80. So we have a difference of $20. This is the difference of $20 and we need to know what do we need to do with this difference. So this is the lesson for today. Now before we proceed any further, most likely you are an accounting students or a CPA candidate. That's why you are watching either or I'm going to ask you to go step further, go to my website farhatlectures.com where I have additional resources, lectures, multiple choice through false exercises that's going to help you understand this topic as well as other topics. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation. If you're watching, please click on the like button. It doesn't, it's not going to cost you anything. If you like it, like it, it will help others as well connect with me on Instagram, Facebook, Twitter and Reddit. Now the best way is to work an example to illustrate the concept. Adam, actual overhead for the year was $775,000 with a total direct labor of $150,000 worked hour on jobs. So basically we have a manufacturing overhead account. And remember this is the actual, this is the actual. How much overhead was applied to Adam's job during the year? Well, how do we apply? Well, we're going to have a predetermined overhead rate and that this happens to be $5 per direct labor hour. Now you have to understand the predetermined overhead rate is predetermined. It's computed before we start the production period. Therefore it's estimated. Now, if it's estimated at $5 per direct labor hour and we consume 150,000 hours, let's see how much was applied. We'll take the predetermined overhead rate $5 times the actual direct labor. And we saw all of this in a prior session when we talked about the overhead. And that's going to give us applied $750,000. So what happened here? The actual was more than the estimated. So we underestimated. We underestimated by $25,000. The question becomes what do you do with this $25,000? Manufacturing overhead will need to be closed. That's a temporary account will need to be closed. Well, it cannot stay in manufacturing overhead. We have to transfer it. And let's think about the transfer in it in the first place. What happened is this? We incurred $775,000, but we actually recorded in work-in-process $750,000. What does that mean? It means we underreported our cost. So what do we have to do? We have to go back. And if we have in cost of goods sold, let's assume in cost of goods sold, we have $3,450,000, we are going to transfer, close manufacturing overhead. We're going to credit manufacturing overhead and transfer it to cost of goods sold which in turn would increase cost of goods sold because we underestimated now we make it up in cost of goods sold and now manufacturing overhead is basically zero whether it's a debit or a credit it doesn't matter it's zero so the point to remember is this manufacturing overhead is close to cost of goods sold now if i have a debit if i have a debit balance i'm gonna have to credit overhead then i'm gonna have to debit cost of goods sold if i'm debiting cost of goods sold i'm increasing my cost hopefully this makes sense let's change the example a little now the actual overhead was 710 the actual overhead was 710 and the applied is 750 what happened here is we overestimated by 40 000 again we have to close it how do we close it we are going to debit and we are going to credit close it to cost of goods sold what happened is this we reduce our cost of goods sold by 40 000 why because we overestimated our overhead now we need to fix it to fix it you will reverse it to fix it you will reverse it and we're closing it to cost of goods sold now is this the only place where you can close overhead we can also close the remaining overhead which is either under applied or over applied to cost of goods sold finished goods and work in process so let's see how it works let's assume back to the previous scenario we have 40 000 and we overestimated our manufacturing overhead now rather than closing the whole 40 000 to cost of goods sold what we're gonna do we're gonna take this 40 000 and rather than hitting the income statement all of it we're gonna take the 40 000 spread some of it to work in process spread some of it to finished goods and spread some of it to cost of goods sold this happens when the overhead is large and you don't want the the overhead difference is large whether it's over applied or under applied to hit to hit cost of goods sold so that's why you will do it so let's go ahead and apply this so let's assume for a particular company work in process is 860 finished goods is 210 and cost of goods sold is 415 if we add those three accounts equal to 711 now we find the percentage at the percentage from the total so work in process is 12 which is 86 000 divided by 711 000 sorry finished goods the same thing will take 210 divided by 711 and cost of goods sold 450 divided by 711 therefore what's gonna happen we're gonna allocate 12 of the difference to work in process 30 to finished goods and 58 to cost of goods sold so here's what's gonna happen 40 000 times 12 40 000 times 30 40 000 times 58 it's gonna give us those figures now the entry would look something like this we're gonna debit manufacturing overhead to make it go down to zero we're gonna debit manufacturing overhead to reduce it down to zero and we are going to credit reduce work in process reduced finished goods and reduce cost of goods sold because originally we overestimated cost of goods sold what should you do now go to farhatlectures.com and work multiple choice questions about this topic through false exercises that's gonna help you reinforce it this is an easy topic easy points perfect it invest in yourself invest in your career good luck and study hard