under- and over-applied overhead

Because overhead is applied to jobs using an estimated rate set before the year even starts, the amount charged to products and the amount the factory actually spent on overhead almost never come out equal. If, by year-end, you applied less overhead to products than you actually incurred, overhead is under-applied (products were charged too little). If you applied more than you incurred, it is over-applied (products were charged too much). This leftover difference is what 'under- and over-applied overhead' names.

Mechanically, the Manufacturing Overhead account collects actual overhead on the debit side as real costs arrive, and applied overhead on the credit side via the predetermined rate. At period-end, a debit balance means actual exceeded applied — under-applied; a credit balance means applied exceeded actual — over-applied. Suppose actual overhead was 620,000 dollars but only 600,000 dollars was applied: overhead is under-applied by 20,000 dollars, meaning product costs to date are understated by that amount. The account must be closed out so it ends at zero. Two causes mingle in this gap: a forecasting error in setting the rate, and the real difference between budgeted and actual activity and spending.

Resolving the difference is required because the overhead account can't carry a balance into the financial statements. If the amount is immaterial, firms simply close it to Cost of Goods Sold — under-applied raises COGS (lowering income), over-applied lowers it. If it is material, the amount is prorated across Work in Process, Finished Goods, and Cost of Goods Sold in proportion to the overhead each contains, so all three inventory and expense figures are corrected. A common misconception is that over-applied overhead is automatically good news; it just means the rate was set high relative to actuals — it says nothing on its own about whether the business performed well.