Why are overhead costing methods using a plantwide overhead rate no longer adequate for pricing products and services?

Answer 1

With advancing technology and intense competitions, companies will strive to provide wider varieties of goods and services. Companies will thus produce both simple and complex products. Complex products tend to consume more non-unit level activities. Examples of non-unit level activities are setups, inspections and equipment maintenance, etc. When there is a large proportion of non-unit level activities, plant-wide overhead rate and departmental overhead rates will result in inaccurate costing. This is because the two traditional methods use unit-level cost driver that cannot capture non-unit level activities with precision. An example of unit-level cost driver is machine hours, since every product requires machine time. Usually complex products are produced in lower volume than simple products. Since the traditional costing methods use a unit-level cost driver, simple products will have higher overhead costs than the complex products. The products will thus be priced higher. The complex products, which use more non-unit level activities are priced lower. Logically, complex products are more expensive than simpler products because of their more complicated production processes. These production processes involve more non unit-level activities. The inaccurate costing leads to inaccurate prices of products, i.e. overpricing the simpler products and underpricing the complex products. The overpriced products might lead the firm to shut down its production unit due to low demand. Similarly, the underpriced complex products will have unexceptionally higher demand. This will undermine the true profits made by the firm. Because although higher demands lead to higher sales, the revenue that the firm collects are, in fact, less than what it supposed to get, if proper costing method is used, e.g. ABC Costing. Companies will incur losses instead because of the high expenses incurred that are not captured in producing the complex products. Hence, the plant-wide rate and departmental rates are no longer adequate to use for costing products. With advancing technology and intense competitions, companies will strive to provide wider varieties of goods and services. Companies will thus produce both simple and complex products. Complex products tend to consume more non-unit level activities. Examples of non-unit level activities are setups, inspections and equipment maintenance, etc. When there is a large proportion of non-unit level activities, plant-wide overhead rate and departmental overhead rates will result in inaccurate costing. This is because the two traditional methods use unit-level cost driver that cannot capture non-unit level activities with precision. An example of unit-level cost driver is machine hours, since every product requires machine time. Usually complex products are produced in lower volume than simple products. Since the traditional costing methods use a unit-level cost driver, simple products will have higher overhead costs than the complex products. The products will thus be priced higher. The complex products, which use more non-unit level activities are priced lower. Logically, complex products are more expensive than simpler products because of their more complicated production processes. These production processes involve more non unit-level activities. The inaccurate costing leads to inaccurate prices of products, i.e. overpricing the simpler products and underpricing the complex products. The overpriced products might lead the firm to shut down its production unit due to low demand. Similarly, the underpriced complex products will have unexceptionally higher demand. This will undermine the true profits made by the firm. Because although higher demands lead to higher sales, the revenue that the firm collects are, in fact, less than what it supposed to get, if proper costing method is used, e.g. ABC Costing. Companies will incur losses instead because of the high expenses incurred that are not captured in producing the complex products. Hence, the plant-wide rate and departmental rates are no longer adequate to use for costing products.

Answer 2

The main reason is over-reliance on volume as a basis for allocating overhead costs where products differ regarding the number of units produced, lot size, or complexity of production.