Which of the following is a result of cost distortion?
1. Accurate costing of all products
2. None of these answers are correct
3. Overcasting of all products
4. Overcasting of some products and under costing of other products
5. Undercoating of all products
The Correct Answer and Explanation is :
Correct Answer:
4. Overcasting of some products and undercosting of other products
Explanation:
Cost distortion occurs when the costs allocated to products or services do not accurately reflect the resources consumed in producing them. This misallocation of costs is often the result of using inappropriate cost allocation methods, such as traditional costing systems that allocate overhead based solely on a single cost driver (e.g., direct labor hours or machine hours). Such methods fail to account for the complexity and diversity of production processes, leading to inaccuracies.
Why Overcasting and Undercosting Occur:
- Overcasting:
- Some products are assigned a disproportionately high share of overhead costs, inflating their cost. This happens when high-volume or simple-to-produce products are burdened with excessive overhead allocation due to their higher activity levels.
- For example, a product requiring minimal machine time but produced in large quantities might be overcosted in systems using machine hours as the sole cost driver.
- Undercosting:
- Other products are assigned a disproportionately low share of overhead costs, understating their true cost. This typically happens with low-volume, complex, or specialized products that consume more overhead resources but are not allocated enough costs due to inappropriate cost drivers.
- For example, a custom-made product requiring multiple setup activities and engineering support might be undercosted if those activities are not accounted for properly.
Implications of Cost Distortion:
- Pricing Errors: Overcosted products may be overpriced, reducing their competitiveness, while undercosted products may be underpriced, leading to potential losses.
- Profitability Misjudgments: Companies may focus on seemingly profitable products (undercosted) while neglecting or discontinuing products that appear unprofitable (overcosted).
- Inefficient Decision-Making: Resource allocation and strategic decisions based on distorted costs are likely to be flawed.
By adopting Activity-Based Costing (ABC), businesses can reduce cost distortion by assigning overhead based on actual resource consumption, improving accuracy and decision-making.