Underapplied overhead refers to the amount of actual factory overhead costs that are not allocated to units of production. This situation arises when the standard allocation amount per unit of production does not equate to the actual amount of overhead costs incurred in a reporting period. A standard allocation is used, rather than the actual allocation, when management wants to be consistent in applying the same overhead cost to units of production throughout the year. This standard allocation amount is usually based on the historical amount of factory overhead incurred, adjusted for projected changes in overhead costs during the upcoming year.
Underapplied overhead indicates that the actual amount of factory overhead incurred was greater than expected. For example, the standard allocation rate might be designed to allocate $200,000 of factory overhead to units of production, and there is an underapplication of $25,000. This implies that the actual cost incurred was $225,000, rather than the $200,000 upon which the allocation rate was based.
When overhead is underapplied, the excess amount of the actual overhead cost over the amount applied may be recorded as a short-term asset, on the assumption that it will be offset in a later period by an overapplication of overhead. The amount of this asset should be charged to the cost of goods sold no later than the end of the fiscal year, so that it does not appear in the year-end balance sheet of the reporting entity.