Ever found yourself unsure how to wrap up your books at the end of a manufacturing period? Closing the manufacturing overhead account can be confusing, yet it’s crucial for accurate financial statements and informed business decisions. Getting it right ensures your costs are correctly matched and your profit figures are reliable.
In this article, we’ll demystify the process step by step, offering practical tips and insights to help you confidently close your manufacturing overhead account.
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How to Close the Manufacturing Overhead Account: A Comprehensive Guide
Closing the manufacturing overhead account is an essential accounting step for any business that produces goods. If you’re involved in manufacturing, understanding this process ensures the accuracy of your cost of goods sold and ultimately leads to better financial decision-making. Let’s break down exactly what manufacturing overhead is, why it matters, and how you can efficiently close the associated account at the end of your accounting period.
What Is Manufacturing Overhead?
Manufacturing overhead includes all the indirect costs that go into producing your products. These costs are not directly traceable to particular units, but they are vital for manufacturing operations.
Some Common Examples of Manufacturing Overhead:
- Factory rent and utilities
- Depreciation on manufacturing equipment
- Indirect labor (e.g., maintenance staff, supervisors)
- Indirect materials (e.g., cleaning supplies, lubricants)
- Factory insurance and property taxes
These costs are accumulated in an account called “Manufacturing Overhead” and applied to the products using a predetermined overhead rate.
Why Is Closing the Manufacturing Overhead Account Important?
At the end of each period, the amounts you’ve applied (charged) as overhead to manufactured goods may not exactly match the actual overhead costs incurred. This leaves the Manufacturing Overhead account with a balance—either overapplied (too much assigned) or underapplied (too little assigned).
Why It Matters:
- Keeps product costs accurate: Ensures that your cost accounting reflects reality.
- Affects financial statements: Unadjusted overhead can distort cost of goods sold and net income.
- Provides operational insights: Reveals if your estimated overhead rates are consistently too high or low.
The Core of the Process: Recognizing Overapplied vs. Underapplied Overhead
Before closing the account, you must determine if the balance is overapplied or underapplied.
- Overapplied Overhead
- Applied overhead exceeds actual overhead incurred.
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The balance in the Manufacturing Overhead account is a credit.
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Underapplied Overhead
- Applied overhead is less than actual overhead incurred.
- The account’s balance is a debit.
Step-by-Step: How to Close the Manufacturing Overhead Account
Let’s walk through the process in organized steps.
1. Calculate Actual and Applied Overhead
- Actual Overhead: Total of all actual indirect costs incurred during the period, recorded throughout the period.
- Applied Overhead: The amount allocated to jobs/products, using a predetermined rate (often based on direct labor hours, machine hours, etc.).
2. Identify Overapplied or Underapplied Amount
Subtract applied overhead from actual overhead:
– If the result is positive: Underapplied overhead (more costs than allocated).
– If negative: Overapplied overhead (allocated more than incurred).
3. Decide How to Close the Balance
There are two primary approaches:
a. Directly to Cost of Goods Sold (Simplest and Most Common Method)
- All over- or underapplied overhead is closed directly to the Cost of Goods Sold (COGS) account.
- Most appropriate when the difference is not material.
b. Allocated Between Inventory and COGS (If Material)
- If the balance is significant, it’s more accurate to allocate over/underapplied overhead among:
- Work in Process Inventory
- Finished Goods Inventory
- Cost of Goods Sold
4. Make the Journal Entry
For Underapplied Overhead
- The total actual overhead is greater than the overhead applied.
- You need to add the difference to COGS.
Journal Entry (if closing to COGS):
Debit: Cost of Goods Sold
Credit: Manufacturing Overhead
- This increases expenses, reflecting the additional overhead that should have been applied.
For Overapplied Overhead
- The total actual overhead is less than the overhead applied.
- You need to reduce COGS by the difference.
Journal Entry:
Debit: Manufacturing Overhead
Credit: Cost of Goods Sold
- This reduces expenses, as less overhead was required than what was assigned.
5. Double-Check and Document
- Review your calculations for accuracy.
- Ensure that the Manufacturing Overhead account is zeroed out at period end.
- Maintain documentation for your audit trail.
Example: Closing the Manufacturing Overhead Account
Let’s see how this works in practice.
Scenario
- Actual Overhead incurred: $105,000
- Applied Overhead: $100,000
Step 1: Identify Amount
- Underapplied by $5,000 ($105,000 actual – $100,000 applied).
Step 2: Journal Entry
Debit: Cost of Goods Sold $5,000
Credit: Manufacturing Overhead $5,000
The Manufacturing Overhead account balance is zero after this entry, and COGS increases for the underapplied overhead.
Benefits of Properly Closing Manufacturing Overhead
- Accurate Product Costing: Prevents misstatements in unit costs.
- Reliable Financial Reports: Avoids artificially inflating or deflating profits.
- Compliance: Satisfies accounting standards and internal policy.
- Improved Budgeting: Helps in setting better overhead rates for future periods.
Challenges and Best Practices
Challenges You Might Face
- Determining the best base for applying overhead.
- Dealing with significant fluctuations in actual overhead.
- Deciding when the difference is “material” enough to allocate among inventory accounts.
Best Practices
- Monitor Regularly
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Track overhead variances during the period, not just at the end.
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Stay Consistent
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Use the same allocation base and closing method unless justified by a change in operations or materiality.
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Document Everything
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Keep detailed records of overhead incurred, applied, and entries made.
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Review Overhead Rates Annually
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Adjust your predetermined overhead rates based on actual historical costs.
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Train Your Staff
- Ensure your accounting team understands both the why and the how of closing overhead accounts.
Practical Tips for Streamlining the Closing Process
- Use accounting software: Automate calculations and entries to reduce errors.
- Schedule regular reviews: Don’t wait until year-end to identify variances.
- Work closely with production managers: Their insights help explain overhead variances.
- Create checklists: Standardize your month-end or year-end closing routines.
- Educate non-financial managers: Help the broader team understand why overhead management matters.
Frequently Asked Questions (FAQs)
What exactly is overapplied manufacturing overhead?
Overapplied manufacturing overhead occurs when the overhead applied to products (using your predetermined rate) exceeds the actual overhead costs that occurred during the period. This produces a credit balance in the overhead account, meaning you assigned too much cost to your products.
How do I know whether to close to cost of goods sold or allocate among accounts?
Close directly to cost of goods sold if the over- or underapplied amount is small—this keeps things simple. If it’s large and could significantly affect inventory valuations, allocate the difference among work in process, finished goods, and cost of goods sold for more accuracy.
What happens if I forget to close the manufacturing overhead account?
If you don’t close the manufacturing overhead account, you could report incorrect cost of goods sold and profit figures. Unclosed balances make your financial statements inaccurate and can impact business decisions and tax reporting.
Is there an industry standard for the overhead allocation base?
Many companies use direct labor hours, machine hours, or direct labor costs as their allocation base. The best base depends on your production process—choose the one that most directly relates to how overhead is incurred in your business.
Can I change the predetermined overhead rate during the year?
Generally, companies set their predetermined overhead rate at the start of the year and use it all year for consistency. However, if there’s a significant, unforeseen change in costs or production volume, some companies may update their rate, but should do so with proper documentation.
Conclusion
Closing the manufacturing overhead account is vital for accurate, reliable accounting in manufacturing businesses. By understanding the concepts of overapplied and underapplied overhead, knowing the right journal entries to make, and following best practices, you ensure your product costing and reporting stay on track. Periodic review, documentation, and collaboration across departments will help streamline this process and support sound financial management.
Remember, mastering these steps is not just about getting numbers right—it’s about ensuring your business is positioned for informed decisions and ongoing success in a competitive environment.
