Absorbed overhead is manufacturing overhead that has been applied to products or other cost objects. Overhead is usually applied based on a predetermined overhead allocation rate. Overhead is overabsorbed when the amount allocated to a product or other cost object is higher than the actual amount of overhead incurred, while the amount is underabsorbed when the amount allocated is lower than the actual amount of overhead incurred.
Over time, the overhead allocation rate should be adjusted to bring the amount of overhead absorbed into alignment with the amount of overhead actually incurred. This means the amount of overabsorbed and underabsorbed overhead should eventually offset each other.
For example, Higgins Corporation budgets for a monthly manufacturing overhead cost of $100,000, which it plans to apply to its planned monthly production volume of 50,000 widgets at the rate of $2 per widget. In January, Higgins only produced 45,000 widgets, so it allocated just $90,000. Also, the actual amount of manufacturing overhead that the company incurred in that month was $98,000. Therefore, Higgins experienced $8,000 of underabsorbed overhead.
In February, Higgins produced 60,000 widgets, so it allocated $120,000 of overhead. Also, the actual amount of manufacturing overhead that the company incurred in that month was $109,000. Therefore, Higgins experienced $11,000 of overabsorbed overhead.
Absorbed overhead is also known as applied overhead. Underabsorbed overhead is also known as underapplied overhead, while overabsorbed overhead is also known as overapplied overhead.