Question

Conventional costing will always distort product costs.’ Discuss the validity of this statement.

Answer 1

BASIC CONCEPT:-

TRADITIONAL COSTING (also referred as conventional costing) is the allocation of factory overhead to products based on the volume of production resources consumed. Under this method, overhead is usually applied based on either the amount of direct labour hours consumed or machine hours used. The trouble with traditional costing is that factory overhead may be much higher than the basis of allocation, so that a small change in the volume of resources consumed triggers a massive change in the amount of overhead applied. This is a particularly common issue in highly automated production environments, where factory overhead is quite large and direct labor is close to nonexistent.

EXAMPLE:-

A traditional costing calculation might find that factory overhead should be charged to products at the rate of $500 per direct labor hour, so if there is a slight change in the production process that increases direct labor by one hour, the cost of the product has just increased by $500 of overhead. Such a large change in applied overhead is nonsensical, since there is not always a direct relationship between the volume of production resources and factory overhead.

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REASONS FOR PRODUCT COST DISTORTIONS UNDER TRADITIONAL COSTING:-

There are two main causes of product cost distortions in conventional costing, i.e., where a single production volume based overhead rate is used by each product department.

These include:-

1. Product volume differences (or product volume diversity) and

2. Product differences (or product diversity).

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1. Product Volume Diversity

Cost distortions from product volume differences occur when a company produces one, or more, high volume products (i.e., a relatively large number of units) and one, or more low volume products (i.e., a relatively small number of units). Generally, the low volume products will receive too little overhead when a single production volume based departmental rate is used and high volume products will receive too much overhead. Conceptually, the idea is that each type of product requires engineering, purchasing, inspection and other support, regardless of the number of units produced, thus these support costs do not vary in proportion to the number of units, but instead vary with other factors that are unrelated to production volume. If the costs of support activities are allocated to products on the basis of a production volume related measurement such as direct labor hours, low volume products will not receive cost allocations in proportion to their demands on these activities.

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2. Product Diversity

Cost distortions from product differences occur when there are variations in product size and product complexity. Small products tend to require less production volume related input (such as direct labor time) than large products, although they do not require less support in proportion to their size. Therefore small products tend to be undercosted, while large products tend to be overcosted.

Product complexity generally refers to product design complexity. Products with complex designs are likely to require more engineering work, more materials related support (e.g., purchasing and materials movement), perhaps longer machine setups and more inspections than less complex products. These additional demands on the various support activities generally cause relatively complex products to be undercosted and relatively simple products to be overcosted. In addition, products that require a relatively large number of parts, unique parts and relatively more, long or complex machine setups tend to be undercharged with overhead while products that require relatively few parts, common parts, relatively few setups, short or simple setups tend to be overcharged.

CONCLUSION:-

Accordingly, the given statement is correct.