The Perils Of Cost Allocation Based On Production Volumes

For companies that offer multiple products in a product line, accurate product costing is critical to product pricing, introduction, and emphasis. Traditional and modern approaches to product costing can be dramatically deceiving about product profitability. A simplified case situation is used to illustrate 3 different product costing systems, one of which, transaction costing, should be used more widely. The other 2 systems, which are based on throughput or output volumes, fundamentally misallocate overhead to products. High volume products will be overcosted relative to the low volume products, to the extent that overhead cost is driven by transactions that are not proportional to output volume. On the other hand, transaction volume is a better substitute for long-run variable cost than is output volume. Transaction-based costing can help clarify the cost dimension of pricing and product emphasis decisions.