Undercosting and Overcosting

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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:

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. Emma would probably object to paying $27 because her actual cost is only $15; she ordered the lowest-cost entree, had no dessert, and had the lowest-cost drink. When costs are averaged across all four diners, both Emma and Matthew are overcosted, James is undercosted, and Jessica is (by coincidence)  accurately costed.Broad averaging can lead to undercosting or overcosting of products or services:

Product undercosting a product consumes a high level of resources but is reported to have a low cost per unit (James’s dinner). Product overcosting a product consumes a low level of resources but is reported to have a high cost per unit (Emma’s dinner).

 

What are the strategic consequences of product undercosting and overcosting? Think of a company that uses cost information about its products to guide pricing decisions. Undercosted products will be underpriced and may even lead to sales that actually result in losses sales bring in less revenue than the cost of resources they use. Overcosted products lead to overpricing, causing these products to lose market share to competitors producing similar products. Worse still, product undercosting and overcosting causes managers to focus on the wrong products, drawing attention to overcosted products whose costs may in fact be perfectly reasonable and ignoring undercosted products that in fact consume large amounts of resources.

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