When a company allocates more overhead costs to production than it actually incurs, the excess allocation is referred to as an overapplication of manufacturing overhead. This typically happens when the predetermined overhead rate, calculated at the beginning of a period, proves too high in relation to actual overhead costs and activity levels. For example, if a company budgets for $100,000 in overhead based on 10,000 machine hours and applies $10 per machine hour, but only incurs $90,000 in overhead and uses 9,500 machine hours, it has overapplied overhead by $5,000.
Accurate overhead allocation is critical for proper cost accounting and informed decision-making. Overapplication can distort product costs, leading to artificially inflated prices and potentially lost sales opportunities. It can also affect profitability analysis, creating a misleadingly optimistic picture of financial performance. Historically, before sophisticated cost accounting systems, misapplied overhead, both over and under, was a common problem, often leading to significant inaccuracies in financial reporting. Modern ERP systems and better cost accounting practices have helped mitigate this issue, but understanding the underlying principles remains crucial for sound financial management.
