Cost Allocation Trap

Businesses, small and big are almost obsessively focused on allocating a portion of every cost incurred to every unit produced. The distinction between sunk costs and  marginal cost is lost on them. Costs that are incurred regardless of volume produced are spread over units produced. For example, a Cupcake business allocates a portion of the mortgage, insurance and other fixed charges to each cupcake.

The problem is complicated by the way these businesses set pricing, they simply tack on an artificial margin to come up with unit price

Cost Based Pricing: Unit Price = Unit Cost * (1+ % Unit Margin ) (WRONG!)

There is no logic behind the % Unit margin, it is either based on what competitors are reporting or a magic number someone comes up with. An arbitrary number that has no meaning and no indicator of absolute profit becomes the number everyone in the organization works towards. No effort is spared to protect  (and increase)  % Unit Margin leading to drop in absolute profit.

The net result is the business has no way of knowing what the market demand is and how the market will react if they were to change prices. Due to their fixation on protecting he % margin they end up selling at the wrong price and losing out on the absolute profit. Since the unit cost is wrong to start with the % margin leads to higher prices. In addition, in this method of cost allocation, any increase in volume will reduce unit cost and any decrease in volume will increae unit costs (because fixed costs are spread over more units).

Increasing market share requires them to produce more unit and it also helps with reducing unit cost. So they produce more, flood the market and end up discounting heavily, destroying the very margin they were trying to protect.

Businesses are reluctant to give up market share in favor of profit because producing less “eats into % margin”. When business have high market share and operating at near full capacity, the unit cost is at its lowest. Due to the incorrect cost allocation, higher market share is wrongly associated with higher % margin. So businesses spend all energy in defending market share.

If the demand shifts down (due to recession), businesses are reluctant to  reduce volume produced because the decrease in volume increases unit cost and hence “eats into % margin”.

This is the same reason businesses are reluctant to increase prices because any price increase leads to lower volume which affects unit cost and % margin.

What starts as cost allocation mistake leads businesses down the wrong path of protecting market share and % margin.

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