To illustrate the death spiral let's assume that Product X is a simple, high-volume product that requires little manufacturing attention. If the accountant spreads the company's manufacturing overhead costs based on volume, Product X will appear to have high overhead costs. (In reality, Product X causes very little overhead cost especially when compared to the company's many complex, low-volume products.) If management responds to Product X's allocated high overhead costs and 1) seeks a price increase which causes the customer to move the production to a competitor with a lower price, 2) outsources the production, or 3) drops the product, then the company's manufacturing volume will decrease.
If the company does not reduce its fixed overhead to correspond to the decreased manufacturing volume and the accountant continues to spread the overhead costs—including the cost of excess capacity—on the basis of volume, the remaining products will have to be assigned more of the overhead costs. If management again reacts to the new, higher, allocated costs by seeking price increases which cause a loss of sales, outsources production, or drops the products, the company's manufacturing volume will again decrease. If fixed costs are not decreased accordingly and the accountant again spreads the overhead on the basis of a new, even smaller volume, the entire company could die from the high fixed costs and a small volume of products being produced and sold.
To avoid the death spiral, some companies attempt to allocate overhead costs based on activities and product complexities rather than simply spreading them on volume. Also, some companies do not allocate the costs of excess capacity to products in order to minimize the death spiral.
Learn Accounting: Gain unlimited access to our seminar videos, flashcards, visual tutorials, exams, business forms, and more when you upgrade to PRO.