Disposal of Under/Over Applied Overhead

There are two methods of closing out the under or over applied balance in the MO account at the year-end.
1.         Close the balance out to COGS.     This causes the full amount of the adjustment to affect the income statement.     Under applied overhead would increase COGS and reduce net income and over applied overhead would reduce COGS and increase net income.
            Sample entry:  (assuming under applied by $4,200)
            COGS                          $4,200
                  MO                                                $4,200
2.         Close out the under/over applied balance by allocating it to all the accounts that contain MO-applied, namely WIP, FG, and COGS.    The allocation is done on the basis of the % of MO-applied in each of the ending balances of the three accounts relative to the total MO-applied in all three accounts.   If the MO applied component is not readily available, the full cost (DM, DL, and MO applied) in each of the three balances is used instead and the method is the same.
            Example:     Assume under applied overhead is $4,200
The MO-applied component in the ending balances of WIP, FG and    COGS are as follows:
                                          Ending Balances
                        WIP                 $15,000
                        FG                    25,000
                        COGS                60,000
                        Total                $100,000
The allocation is done on a small schedule as follows:
Ending Bal.
% of total
 x under/over applied
= amount allocated
x  $4,200
$   630
x  $4,200
x  $4,200
Entry:               WIP                 $   630
                        FG                     1,050
                        COGS                2,520
                                    MO                  $4,200
Under this method part of the adjustment (the part relating to WIP and FG) goes to the Balance Sheet and does not affect the income statement.    In this example, Net Income would be $630 +$1,050 = $1,680  higher using this method (rather than sending it all to COGS) since $1,680 of additional cost is kept out of the income statement.

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