 In this discussion, we will discuss the discussion question of discuss why the overhead account may have either a debit or credit balance at the end of the period and how to handle it. Okay, so if we see an essay question like this or a discussion question like this, we may first just want to start out with what is overhead, when might a company use overhead, what type of company would use overhead. If we just get that process, we may pick up some points just discussing the overall topic, even if we don't know exactly what is going on with this debit and credit balance business and how to handle that. So the place to start would think would be to think what is overhead. Well, overhead is typically going to be used in a manufacturing type of company. It could be used in a service company, but we're usually thinking about the two types of way to manufacture inventory. And those are going to be a process cost system and a job cost system. When you're thinking about examples between a process cost and a job cost, I would usually pick the job cost system. I think most people are more familiar with that and it might be just more intuitively easy to think through as you go through some of these examples. So I would then go to the job cost system and start to think through what does it mean to be overhead? Overhead within a job cost system and overhead is one of the three components that's going to be included in our inventors. 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 then 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. But whenever we think of inventory, we think it's got at least three things involved. It's got the materials of course, but that's only one component. It's also got the labor and it has the overhead. So what's the overhead going to be? It's going to be all the estimated stuff that we couldn't apply in a job cost system specifically to a job in a process cost system to a process. So we didn't know exactly where to put it and therefore we want to put it into work and process, but we don't know how to support it with the supporting documentation, the job sheets. We don't know which job to put it to, therefore couldn't put it into work and process, but had to put it into this account called overhead. And then that overhead will be applied to work and process. But the only way we can do that is by breaking it out in some way, estimating which jobs it should be applied to. And then we can make the journal entry, removing it from overhead to work and process supporting it with the job cost sheets. So if you imagine what's going to happen in terms of a T account then, and it might be good just to write down the T account, this is a T account for overhead, this can be very ugly T account, but everything on the left side of the T account is actual costs. So what will happen here is we'll have actual costs, which will be things like indirect labor, indirect materials, and anything else on the factory, like utilities on the factory, anything we couldn't apply to the job that's on the factory. So depreciation on equipment, anything in the factory, small, you know, small tools in the factory in any salaries, of course, would be the indirect labor in the salary in the factory that we couldn't apply directly to a job are going to be in there as well, the utilities insurance on the factory. All that stuff is going to be included in overhead, meaning we want to put it in inventory, but we don't know which job to put it to, so we have to put it in the overhead. Then we use some kind of allocation method with the allocated percentages of ownership in order to allocate it out, taking it out of overhead and putting it into where we want it work in process. Now why couldn't we put it in the work in process at the beginning? Because we didn't know which job to put it to. Once we do the allocation method, the allocation method isn't to do this journal entry, which is easy to do. We can do the journal entry, but what's there to do is the supporting documents, the jobs, are going to have multiple jobs, and that's what's being broken out by this number. So this number will be broken out into multiple jobs, and that's what we're going to have. Now this number then is just going to be an estimate, however, because of the way I have it here, and this is the way you probably want to think about it, it looks like it happens all in a nice timely order, meaning we have the incurred, the actual costs in overhead, and then we apply it to the job at the end of the month. But that's not what really happens. What really happens is we apply it to the jobs as we go throughout the time period, and therefore we don't know how much overhead we should really apply because we're applying things like utilities and stuff that's not yet been incurred. That's been incurred, but we don't know what the bill is until the end of the month. So we don't know what overhead really is. So we have to estimate, in other words. So this is an estimated number that we're using to allocate over here. And that means that the actual costs are always going to be different than the estimate because that's what an estimate will be unless we're perfect estimators, which is not likely, then there's always going to be a difference. So that means that if these actual costs, the debits, are bigger than what we allocated out, the credit will be left with a debit balance. And if that happens, we would have underapplied because the actual costs would be greater than what we allocated out. On the other hand, if what we allocated out is greater than the actual costs, the overhead account would be left with a credit. And if the overhead account is left with a credit, then we would have overapplied. We would have applied more than the actual costs. So that's what it means to have a debit or credit balance at the end of this process. Then the question is, well, what do we do with that? What are we going to, is that okay to have a debit or credit balance at the end? And the thing is we want to make it zero at the end because we want to start this process over again next month. We don't want to have this remainder in there. We want to start over. So what we typically do is close this out. We want to make this go to zero then. And now whatever this balance remaining, we want to make it zero. So if it has a credit balance in it at the end of the month, we're going to debit it in order to make it zero. Now typically if it's a small number, which hopefully it is if our estimate was anywhere close, then we're going to put the other side to cost of goods sold. So if there was a credit balance leftover, we're going to debit factory overhead and credit the cost of goods sold. And the cost of goods sold being credited is only just an account that we're using to clear out. So the fact that we're crediting cost of goods sold in that case and making cost of goods sold goes down, which is very unusual. Typically expenses only go up in the debit direction. That's okay typically because it's supposed to be immaterial at this point. If it's a small amount, we're okay with that. We will make cost of goods sold go down so that we can close out the overhead account and start this process over in the next month. If on the other hand the overhead account had a debit balance in it, then we would have to credit the overhead and debit cost of goods sold to make it go down to zero. Now you might be asking why we would reduce the overhead, but why would we put it to cost of goods sold? Because the next step from overhead is work in process and then finished goods and then cost of goods sold. If we followed the chain of events from overhead to when it's finally sold. But the real answer to that is because it's the easiest thing to do to put it to cost of goods sold. Because if we go to cost of goods sold, it's a temporary account which will close out to the retained earnings and we won't have to worry about it again. So the justification for that would be that if it's immaterial and we don't know exactly what happened because it's an estimate, let's do the easiest thing which would be to write it off to an income statement account which will then roll into retained earnings and no longer be bothering us at a later time. And so that's what we end up doing. Which income statement account should we use? Cost of goods sold because that's where it will end up once it finally hits the income statement, once we finally expense this information. Now if this amount, the under or over applied, the debit or credit balance is material. It's significant. It's a lot. We're off by a lot. Our estimate was really off. Then we're going to want to, we can't just write it off. We shouldn't because it's going to distort our net income, affect decision making. So what we then need to do is figure out how we're going to allocate it to the three components where it could be. We're going to have to find out, we're going to have to figure a way to allocate it to either what's still left in work and process, what's in finished goods and what is in cost of goods sold. So again, if it's, if it's in material, we'll just write it off to cost of goods sold. That's the easy thing to do. If it's material, then we need to figure out some allocation method and think more precisely at where we believe it should go. Should it go and that's going to be in three places. We're going to have to allocate to the three places, work and process. I mean, the overhead will go to work and process and then go to finished goods and then cost of goods sold will allocate between those three.