How to use Overlay vs Attachment

You could reference component drawing files in a sub-assembly drawing file (first level host)

then reference this sub-assembly file in another file (2nd level host) & you could continue to nest references at higher levels.
if you reference a drawing that is already referencing other files, those reference files are nested Xrefs in the current drawing.

Nested Xrefs are simply ignored in the current drawing (they do not display) if they were attached using the Overlay Reference Type

whereas, nested Xrefs are included if they were attached using the Attachment Reference Type.

A circular reference exists when you reference a drawing file that is already referencing the current drawing file.

this can easily happen when you design components that must match or fit together in an assembly.
when mating components reference one another it is easy to verify whether or not these components mate properly.
for example, a Left.dwg file could reference a Right.dwg at the same time that the Right.dwg references the Left.dwg.

You may also see circular references in the construction industry where designers from various disciplines must share design data.

for example, the interior designer may reference the electrical plans to verify that electrical outlets are in appropriate places
and the electrical designer may reference the interior design plans for the same reason.

A warning appears and you are asked if you want to continue when AutoCAD finds a circular reference.

AutoCAD attempts to ignore references to the current drawing if you choose to continue.

Warning: Circular reference from “Left” to “current drawing”. Circular reference(s) have been found. Continue? <N> Y ↵Breaking circular reference from “Left” to “current drawing”.
Command:

A circular reference is a specific nested Xref example
(the current drawing is a nested Xref in the current drawing).

if you always use the Overlay Reference Type you will NOT get circular reference warnings
because all nested Xrefs (including circular references) are ignored with the Overlay Reference Type.
however, these Xrefs can be only one level deep (they will display only in first level hosts).

You must use the Attachment Reference Type to see nested Xrefs in second level (or higher) host drawings.

any circular references that you attempt to make will result in warnings
but AutoCAD may be able to ignore these circular references by breaking references back to the current drawing.

You can toggle the Reference Type setting in the Xref Manager by double-clicking on the word Attach or Overlay under Type.

but you can only change the setting of first level Xrefs this way (you cannot change the status of nested Xrefs).

PRACTICE WITH OVERLAY AND ATTACHMENT REFERENCE TYPES

1) Close all open drawings (if there are drawings open).

»2) Pick File + New. Select Start from scratch. Select English default units and pick OK to create a new drawing.

»3) Pick File + Save. Type Room.dwg as the name in your personal folder. Then pick the Save button there.

»4) Pick Insert + External Reference. Select T202_10.dwg as the file in your personal folder and pick Open to continue. Make sure Reference Type is Attachment. Clear all Specify On-screen boxes and pick OK to continue.

5) Pick View + Zoom + Extents to center the new Xref on the screen. Then pick View + Zoom + Out.

Room.dwg is a first level host to the T202_10.dwg drawing file, which is the floor plan that you see on your screen.

6) Pick Insert + External Reference. Select T202_11.dwg in your personal folder then pick Open to continue. This time change the Reference Type to Overlay and pick OK to create a new Xref in the Room drawing.

7) Save the changes to this drawing and Close the file.

8) Pick File + New. Select Start from scratch. Select Englishdefault units and pick OK to create a new drawing.

9) Pick File + Save. Type Building.dwg as the name in your personal folder. Then pick the Save button there.

Building.dwg could be an assembly (host) drawing in which you attach many different rooms (e.g. Room.dwg) as Xrefs.