Traditional cost allocations are often based on volume such as number of products manufactured, number of direct labor hours, number of production machine hours, number of square feet, etc. Unfortunately, it is becoming more frequent that the common costs or indirect costs that require allocation are not caused by volume. In other words, traditional cost allocations are often based on something other than the root causes of the costs.
It is possible that a significant amount of manufacturing overhead might not be caused by production machine hours, yet the overhead is allocated using those hours. For example, a few of a manufacturer’s low volume products may require significant amounts of engineering changes, additional inspections, frequent machine setups with unusually short production runs, special handling, additional storage, and so on. To allocate these special costs to all products on the basis of the number of production machine hours (instead of allocating those costs based on their root causes) will result in individual product costs that are inaccurate and misleading.
