A plant accountant closes the month with applied overhead of $480,000 but actual overhead of $510,000. The $30,000 underapplied gap has to land somewhere, and the answer depends on materiality and on how WIP, finished goods, and COGS share the burden.
Variable overhead changes in total with activity but stays roughly constant per unit. Components: indirect materials (glue, lubricants, fasteners), indirect labor tied to volume (material handlers, hourly machine operators), utilities driven by machine hours, and production supplies.
Fixed overhead stays constant in total within the relevant range and falls per unit as volume rises. Components: factory rent, property taxes, insurance, salaried plant supervision, and straight-line depreciation on factory equipment.
KEY: The variable/fixed split depends on the planning horizon. Within one month, supervisor salaries and lease payments are fixed. Over three years, the firm can sublease, restructure leadership, or sell equipment, so those costs become variable. State the horizon before classifying.
The allocation base for variable overhead should causally drive the cost: direct labor hours, machine hours, or units produced. Pick the base most tightly correlated with cost behavior.
Common mistakes
- Classifying a cost as fixed without naming the time frame. Within one quarter the supervisor salary is fixed. Over five years headcount is fully variable. Anchor to the relevant range before answering.
- Closing a material overhead variance to COGS only. When the under or overapplied amount is material, you must prorate across WIP, FG, and COGS by applied-overhead proportions, not dump the full amount into COGS.
- Using direct labor hours when machining drives the cost. A base that does not cause the overhead distorts product cost. Indirect machine maintenance correlates with machine hours, not labor hours.
Bottom line
- Variable overhead moves with activity (indirect materials, indirect labor, utilities); fixed overhead stays constant in total within the relevant range (rent, supervision, straight-line depreciation)
- Time frame matters: short-run many costs are fixed; long-run nearly all costs become variable
- Application rate = budgeted overhead ÷ budgeted base, and applied overhead = rate × standard activity; over/underapplied closes to COGS if immaterial, prorates across WIP/FG/COGS if material
- ABC assigns overhead through activity cost pools and drivers; traditional plantwide/departmental rates use volume bases and distort cost when products differ in complexity
Exam shortcut
When applied versus actual differs, immaterial closes to COGS and material prorates across WIP / FG / COGS by applied-overhead proportions. The exam telegraphs which through the word "significant" or by handing you WIP and FG balances explicitly. When two products share machine hours but differ in batch size, the plantwide rate hides cross-subsidy. Switch mentally to ABC and let the low-volume product absorb setup, inspection, and engineering driver costs.
The full lesson (about 1,706 words, 11 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 1D3
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