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.
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