Product-cost cross-subsidization means that if a company undercosts one of its products, it will overcost at least one of its other products. Similarly, if a company overcosts one of its products, it will undercost at least one of its other products. Product-cost cross-subsidization is very common when a cost is uniformly spread—meaning it is broadly averaged—across multiple products without managers recognizing the amount of resources each product consumes.
In the restaurant-bill example, the amount of cost cross-subsidization of each diner can be readily computed because all cost items can be traced as direct costs to each diner. If all diners pay $27, Emma is paying $12 more than her actual cost of $15. She is cross-subsidizing James who is paying $15 less than his actual cost of $42. Calculating the amount of cost cross-subsidization takes more work when there are indirect costs to be considered. Why? Because when two or more diners use the resources represented by indirect costs, we need to find a way to allocate costs to each diner. Consider, for example, a $40 bottle of wine whose cost is shared equally. Each diner would pay . Suppose Matthew drinks two glasses of wine, while Emma, James, and Jessica drink one glass each for a total of five glasses. Allocating the cost of the bottle of wine on the basis of the glasses of wine that each diner drinks would result in Matthew paying and each of the others paying . In this case, by sharing the cost equally, Emma, James, and Jessica are each paying more and are cross-subsidizing Matthew who is paying less for his wine for the night.
To see the effects of broad averaging on direct and indirect costs, we next consider Plastim Corporation’s costing system.