Overabsorbed is usually used in the context of a manufacturer’s production overhead costs. Since manufacturing overhead costs are not directly traceable to products, they need to be allocated, assigned, or applied to the products through an overhead rate. We also state that the products absorb the overhead costs through the overhead rate.

The overhead rate is normally a predetermined rate—meaning that it was calculated prior to the start of the accounting year by using 1) the expected amount of overhead costs, and 2) the expected volume of production. Because of these two estimates, it is unlikely that the amount of overhead allocated, applied, assigned, or absorbed will be equal to the actual overhead costs incurred.

If the actual products manufactured are assigned or absorb more overhead through the overhead rate than the actual amount of overhead costs incurred, the products have overabsorbed the overhead costs.

At the end of the accounting year, the amount of the overapplied, overassigned, or overabsorbed overhead is often credited to the cost of goods sold. The reasons are 1) the overabsorbed amount is not significant, and 2) most of the products absorbing too much overhead costs have been sold. If the overabsorbed amount is significant, then the amount overabsorbed must be prorated or allocated as a reduction to the cost of the inventories and to the cost of goods sold based on where the overabsorbed overhead costs are residing at the end of the accounting year.

Learn more about Manufacturing Overhead and Standard Costing.

A cost might be an expense or it might be an asset. An expense is a cost that has expired or was necessary in order to earn revenues. We hope the following three examples will illustrate the difference between a cost and an expense.

A company has a cost of $6,000 for property insurance covering the next six months. Initially the cost of $6,000 is reported as the current asset Prepaid Insurance. However, in each of the following six months, the company will report Insurance Expense of $1,000—the amount that is expiring each month. The unexpired portion of the cost will continue to be reported as the asset Prepaid Insurance.

The cost of equipment used in manufacturing is initially reported as the long lived asset Equipment. However, in each accounting period the company will report part of the asset’s cost as Depreciation Expense.

A retailer’s purchase of merchandise is initially reported as the current asset Inventory. When the merchandise is sold, the cost of the merchandise sold is removed from Inventory and is reported on the income statement as the expense entitled Cost of Goods Sold.

The matching principle guides accountants as to when a cost will be reported as an expense.

Learn more about this topic at Accounting Principles and Adjusting Entries.