Question

Walker Enterprises, Inc., uses a job-order costing system and sets a predetermined overhead rate at the beginning of each year based on estimated manufacturing overhead costs and estimated direct labor-hours for the upcoming year.

If the company sets its prices to cover actual direct materials costs, actual direct labor costs, and applied manufacturing overhead costs, will the company at least avoid a loss during the year?

Answer 1

The absorption differences in manufacturing overhead could be of two reasons-
(i) Normal reasons- This could happen when there is variance in efficiency and usage of overheads and also slight change in prices.
(ii) Abnormal reasons- This could happen when there are circumstances beyond the control of entity, such as exhoribant change in prices of overheads, breakdown of machinery, etc.

So, when an entity covers its prices of goods with the actual direct material costs, actual direct labour costs and applied manufacturing overhead, then there is good chance of avoiding any loss.

However, it is recommended to provide for certain margin, in order to cover any loss due to abnormal reasons.