Unit Costing: Coster Beware the Insidious Averaging Impact
Cost per unit can be a dangerous metric as averaging can have undesirable insidious consequences when units are non-homogeneous. The illustration shows what can happen when prices are based on a markup from unit cost.
Unit cost is a common managerial costing metric. It is simply a total cost divided by the number on units. However, coster beware. Unit costing can grossly misstate individual component costs when the units are not similar.
Consider a classroom exercise. We imagine starting a company that sells things students commonly buy. We ask for recent purchases from the class and come up with a list of a personal computer, a car, a cup of coffee, lunch and a watch. This will be our product portfolio.
Then we install a unit costing system to calculate the unit costs of our product. After adding 30% to cover overhead and profit we then set our prices as a markup from unit cost.
The illustration shows that we will price our entire product portfolio at $5774.86 each. Note that we have calculated this to the penny! We could have gone to ten decimal places of accuracy. Some people are impressed with that. Don’t be.
Think about how this business will fare when it opens its doors. There will be a great rush to buy up the obviously underpriced car. Imagine getting a twenty thousand dollar car for $5774.86. However, none of the other products will sell. No one is going to pay $5774.86 for a cup of coffee! The company will fail.
Unit costing is essentially an average cost per unit. When dissimilar things are averaged the average becomes meaningless. While the average might be precisely correct, it may be completely wrong for each individual component. Think of this as being precisely wrong!
Does this example seem preposterous? While admittedly the numbers are deliberately somewhat extreme, reliance on costing is very common in price setting. Errors in the costing methodology can have the same insidious effect. Averages are useful when the components being averaged are identical or similar. This is called homogeneity.
Averaging in Allocation's Bases of Distribution
When choosing a basis of allocation we are making a big assumption about averaging. We are implicitly assuming that the average cost per unit of the basis is reasonable. (Note, I say reasonable because there will always be some error when choosing a basis of allocation.) We do this to simplify the allocation process, to make the costing easier to understand, to minimize the cost of the costing process, and to avoid detailed record keeping.
Making assumptions is inescapable in managerial costing. There is simply too much to measure and too many ways to measure it. Reasonable assumptions simplify and facilitate the measurement process. Bad assumptions can result in poor management decision making and/or a loss of credibility of the costs.
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