Broad Averaging and Its Consequences

Learning Objective 1 Explain how broad averaging undercosts and overcosts products or services

Historically, companies (such as television and automobile manufacturers) produced a limited variety of products. These companies used relatively few overhead resources to support their operations, so indirect (or overhead) costs were a relatively small percentage of total costs. Managers used simple costing systems to allocate overhead costs broadly in an easy, inexpensive, and reasonably accurate way. But as product diversity and the proportion of indirect costs increased, broad averaging led to inaccurate product costs. That’s because simple peanut-­butter costing (yes, that’s what it’s called) broadly averages or spreads the cost of resources uniformly to cost objects (such as products or services) when, in fact, the individual products or services use those resources in nonuniform ways.

Undercosting and Overcosting

The following example illustrates how averaging can result in inaccurate and misleading cost data. Consider the cost of a restaurant bill for four colleagues who meet monthly to discuss business developments. Each diner orders separate entrees, desserts, and drinks. The restaurant bill for the most recent meeting is as follows.

<p>A table shows a restaurant bill</p>

The table depicts charges for entree, dessert, drinks, and total for Emma, James, Jessica, and Matthew, as well as the total and average for each category. The details of the table are as follows:

  1. Entree
    • Emma: 11 dollars
    • James: 20 dollars
    • Jessica: 15 dollars
    • Matthew: 14 dollars
    • Total: 60 dollars
    • Average: 15 dollars
  1. Dessert
    • Emma: 0 dollars
    • James: 8 dollars
    • Jessica: 4 dollars
    • Matthew: 4 dollars
    • Total: 16 dollars
    • Average: 4 dollars
  1. Drinks
    • Emma: 4 dollars
    • James: 14 dollars
    • Jessica: 8 dollars
    • Matthew: 6 dollars
    • Total: 32 dollars
    • Average: 8 dollars
  1. Total
    • Emma: 15 dollars
    • James: 42 dollars
    • Jessica: 27 dollars
    • Matthew: 24 dollars
    • Total: 108 dollars
    • Average: 27 dollars

If the $108 total restaurant bill is divided evenly, $27 is the average cost per diner. This cost-averaging approach treats each diner the same. When costs are averaged across all four diners, both Emma and Matthew are overcosted (the cost allocated to them is higher than their individual cost), James is undercosted (the cost allocated to him is lower than his individual cost), and Jessica is (by coincidence) accurately costed. Emma, especially, may object to paying the average bill of $27 because her individual bill is only $15.

Broad averaging often leads to undercosting or overcosting of products or services:

What are the strategic consequences of product undercosting and overcosting? Suppose a manager uses the product cost reported by the cost measurement system to guide pricing decisions. Undercosted products will be underpriced. The revenue from undercosted products may even be below the cost of the resources that are used to produce them, thus leading to losses for the organization. Overcosted products will be overpriced, potentially leading to losses in market share to competitors selling similar products at lower prices.

What if sale prices of products, such as refrigerators, are determined by the market based on consumer demand and competition among companies? Consider a company manufacturing two types of refrigerators, a simple one and a complex one with a number of different internal compartments, temperature settings, and vents. Suppose the complex refrigerator is undercosted and the simple refrigerator is overcosted. In this case, the complex refrigerator will appear to be more profitable than it actually is while the simple refrigerator will appear to be less profitable than it actually is. Managers may strategically promote the complex undercosted refrigerators, thinking they are highly profitable, when in fact these refrigerators consume large amounts of resources and may be far less profitable than they appear. Managers may, in turn, underinvest in the simple overcosted refrigerator, which shows low profits when in fact the profits from this refrigerator may be considerably higher. Alternatively, they may focus on trying to reduce the cost of the simple refrigerator to make it more profitable when, in fact, this refrigerator is reasonably profitable and the opportunities to reduce its costs may be quite limited.