Question

Product Management:

Why do cost allocations cause inappropriate pricing decisions? What types of ratios are most useful for Product Managers?

Answer 1

Cost allocation is done when a production unit uses a shared service with other units. The shared cost or indirect cost is also allocated within a production unit, in case the same production unit produces multiple products. Generally, direct labour and material cost are traceable to the particular product but overhead or cost of shared resources like logistics, purchase, quality, maintenance, production supervisor etc are allocated based on a decided ratio on the products.

The allocation of cost if done base on traditional costing system may result into a significant higher or lower costing of a product. Also traditional costing system is adopted when the indirect costs or overheads are lower compared to direct cost.

For example, a factory may decide that indirect costs or overheads to be allocated based on the production volume. In that case, the product which has a higher volume will get the allocation of higher overhead without considering the utilisation rate. This will cause a distorted cost for the product, which will have an impact on the product pricing. We will consider one example here. Say X factory produces two products A & B. The volume of A is 100,000 units and volume of product B is 10,000 units per annum. The direct cost of product A is $ 10 per unit and direct cost of product B is $ 8 per unit. If the plant decides to allocate the cost based on production volume and the total overhead is $1,100,000 for the year, product A will get an allocation of $1,100,000/110000 X 100000 = $1,000,000. This will increase per unit cost of product A by $10 per unit. Therefore the total cost of product A will become Direct Cost ($10) + Allocation of Indirect Cost ($10) = $20 per unit. The companies will certainly target a selling price over $20 based on this costing, which may not be accurate and will lead to market loss.

The ideal way of allocating overhead costs is by adopting Activity Based costing. Under this procedure, a cost driver is determined for each cost element. For example, the cost of purchase team may be allocated based on the number of purchase orders issued and then based on the purchase orders issued for product A & B, the cost of purchase team should be allocated amongst these two products. Similarly, the cost of maintenance team may be divided amongst the product line based on the assets numbers or in case a time sheet is maintained for maintenance call, then based on the time sheet.

Therefore, for a more accurate costing of product, activity based costing for allocating indirect cost should be adopted.