 Within this discussion, we will discuss the discussion question of describe what it means for overhead to be overapplied or underapplied and how to deal with it. If we see a discussion question or essay question like this, and we don't know exactly what it means for overhead to be overapplied or underapplied, we can start off with the definition or thinking about what overhead is, what type of company overhead would fit into it, and then hopefully that can help us pick up some points and possibly jog our memory as to what underapplied or overapplied might mean. So if we think about overhead, we're thinking about a production company typically. We're thinking about a company that's using production or a job cost or a process cost system it's possible to have overhead in a service company as well. But we'll typically think of a company that makes things and then we're going to have overhead. There's going to be three types of things within production. That's going to be direct labor, direct material, and overhead. So overhead of course is that kind of tricky thing that we have because the problem is that we can't apply the overhead if it's a job cost system to a specific job or if it's a process cost system to a specific process. I'll think about a job cost system because it's easier for me to do so. So if we think about we can't apply the overhead cost to a specific job and therefore we put it into the overhead. So the overhead is kind of this dumping ground for us to put these costs that we know that should go. Support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website broken out by category further broken out by course. Each course then organized in a logical reasonable fashion, making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems, PDF files, and more like QuickBooks backup files when applicable. So once again, click the link below for a free month membership to our website and all the content on it. We know it should go into inventory in other words, but we can't apply it to inventory because we don't know which inventory or in this case which job which reflects the inventory we're making. We don't know which one to put it to. So we have to put it into overhead. Why does that help us? Because we're going to later on allocate it to the jobs based on some kind of allocation. We're just going to say we're going to put it here and we'll figure it out later and we'll use some kind of estimate to put it into the actual job. And then later, of course, we're going to have to figure out how to do that. We're going to allocate it out. Now when we allocate it out, we don't allocate actual overhead. We allocate an estimate and there's a few different reasons for that. We allocate an estimate because we don't know what the total cost will be. Number one and that's going to be the main reason we use basically an estimate. We don't know what the costs are at the end of the time period. We're just estimating what they are and we have to record them throughout the time period. Even so, for example, we're using the utility bill in the factory right now and we're allocating part of the overhead being utility that's used in the factory that's going into the inventory. But we haven't paid the utility bill yet until the end of the month. So we don't know exactly what the utility bill is that should be part of overhead that we're going to allocate. So we have to use this estimate. And of course, anytime we use an estimate, it's not going to be precise unless we're perfect, which most of us fall a little short of that. So we're probably going to have, therefore, an underapplied or overapplied overhead, meaning we're going to track the actual overhead that we incur, indirect labor, indirect material, all of the things that are in the factory that are going to help us convert the materials to the finished goods. And then we're going to allocate it using some kind of estimate. So if you think about a T account, we're going to debit everything for the actual costs in overhead. It's going to add up, kind of like inventory has a debit balance, it's kind of like inventories there. It's holding the inventory with a debit because it's an asset type account when it goes in the inventory at least. And then we're going to allocate it. We're going to credit out of the overhead and we're going to put it into the work and process because we can apply it to a job at that point. We'll use some type of estimate to apply it to the job and we'll put it into work and process, which will then be supported by the jobs. So if you think about that, if the debits are greater than the credits when we allocate out to the jobs, then we're going to be off. The debit's being higher than the credits. That means we had more actual costs than we applied out, therefore it would be under applied. So we would have a debit balance remaining if it were under applied. If on the other hand, when we applied it out using our estimate, the credit was larger than the debits were left with a credit balance in the overhead account, we would have then applied out more of the overhead costs than we actually had at the end of the month. We were able to see this only at the end of the month and therefore we would have over applied leaving us with a credit balance in the overhead. Now conceptually, this kind of makes sense. We can say, okay, I know we're going to be under applied or over applied. That makes it an estimate. We're not going to be perfect. I get all that, but should it be a debit balance or a credit balance? What does it mean to be a debit or a credit? Is it under applied or over applied if it's a debit or credit? And then what do we do with it? Well, the only way to really do that is to actually draw up T accounts. So if you see a question like this, Questions? Draw up the T account and put in, you know, direct labor, overhead, and direct materials on the left side, and then put on the right side the allocation that you're going to have. And that'll help you to kind of think about, well, what does it mean if it's a debit balance at the end? Whatever the estimate is, if it's off by an estimate, we're just going to clear it out to zero because we need to start over next time period. So although this isn't really a clearing account, this overhead account, because we're not closing it out to retained earnings, or in other words, it's not a temporary account, because we're not really closing it out to retained earnings. It is temporary in the sense that we are going to force close it out by closing it out someplace in our case to cost a good soul generally, so that we can start the process over. So whatever's left in overhead, what do we deal? How do we deal with this under over applied overhead? Whatever it is, we're going to make it zero. We're going to enter a journal entry to make it zero. If it's small, if it's immaterial, then we're just going to close it out to cost of good sold. Why? Because that's the easiest thing to do. Okay, so first, why is it the easiest thing to do? Because cost gets sold, we want to close it out to an income statement account because the income statement accounts will then roll into retained earnings and in essence disappear. So we won't be dealing with them. Not permanent accounts are temporary. Once it goes away, then we won't have to deal with it kind of in the future. Cost of good sold is the most logical place to put it because the inventory will eventually get to cost of good sold when it gets the income statement, meaning the overhead would then go to work and process, then finish goods, then be sold and moved to finally cost of good sold. So that's the logical ending point that it would get to. Our problem of course is we don't know if it should be in cost of good sold or still in work and process or still in finished goods, but we're just going to say it's small. It's immaterial. That's our justification for doing the easy thing, writing it off to cost of good sold because it will not affect decision making given the dollar amount that we are talking about. Now, if the dollar amount is large, if we're saying, oh, that's material, we were off by a lot, then we shouldn't just write it off because it's going to be affecting the financial statements. So in that case, we would want to try to figure out and go back in and try to figure out, okay, how much of this overhead do we believe based on we have to think about how much would still be in work and process, how much would still be in finished goods and how much had yet had already been sold and get more detailed to try to be more precise about this number. Again, if it's small, it's not worth the time and effort to do that because it's immaterial, we'll just write it off to cost of good sold, which hopefully will be the normal practice. So then, of course, what will the journal entry look like? Well, again, if the debits on the T account for overhead are greater than the credits, that means we had more actual costs than what was applied out. And therefore, we under applied, we're left with a debit balance. So we're going to credit the overhead account to make it go to zero. And we're going to debit cost of good sold. And again, cost of good sold here is nothing but just whatever we got to do. So you can't really think of why we're doing it to cost of good sold. We're doing whatever we need to do to get overhead to go to zero. In this case, we needed to credit overhead to make it go to zero, so we had to debit cost of good sold. If on the other hand, we look at our overhead account and the debit side, the actual costs are less than the credit side, the amount we allocated, then we have over applied. So if we're over applied, we have a credit balance. How do we make it go to zero? We do a journal entry with doing the opposite thing to the overhead account. We debit it. We debit overhead to make it go to zero and we credit the cost of good sold. And that's a little bit unusual because again, you're going to say cost of good sold shouldn't be credited. That's unusual. Cost of good sold only goes up with it. It's like an expense. It only goes up in a debit. But this is an exception to the rule in that it's immaterial. Therefore, we're doing whatever we do to make the overhead account go to zero and putting it to cost of good sold. If it's a credit, so be it.