Direct costing with broad overhead: the stage where distortion begins.
At the second stage, the organization calculates direct costs and assigns them to product groups or service lines, then spreads indirect costs with a single, broad allocation. It is a real step up from blind bookkeeping, and it quietly introduces a new problem: the moment overhead is averaged, some things look cheaper than they are and others look dearer.
In short
Stage 2 corresponds to IFAC levels 3D and 4D. Direct material and labour are traced to outputs; indirect and shared costs are added back through one average factor, such as units produced. Useful for a small, low-variety business. Dangerous as variety grows, because a single average cannot follow cause and effect.
Stage 2 of five on the costing maturity ladder. Illustrative.
Stage 2 is where most growing companies live, and where most costing damage is done. The direct costs are handled well: material and labour are traced to product families or service lines, and to that extent the numbers are sound. The trouble starts with everything else. Selling, distribution, administration, support, all the indirect cost that now makes up the majority of spend in most businesses, gets added back with a single blunt instrument, usually a rate per unit or a percentage of direct cost.
Cokins makes a sharp observation about this stage in the IFAC framework: introducing a flawed average allocation can leave you with worse information than you had with direct costs alone. A low-volume, high-complexity product that consumes disproportionate setup, handling and support is charged the same average as a simple high-volume line. The complex product looks profitable; the simple one looks weak. Decisions follow the distortion. You promote the loss-maker and cut the earner.
- Indirect cost is allocated by one factor: headcount, units, square metres or a flat percentage.
- High-variety and low-variety products carry the same overhead rate.
- Small, custom or rush orders look as profitable as large standard ones.
- Margins by product look suspiciously similar, because the averaging flattens them.
- Anyone who looks closely suspects the standard costs are 'a bit off', but cannot prove it.
What it is costing you
An illustrative case. A manufacturer at Stage 2 absorbs factory overhead as a flat rate per labour hour. Two product families show almost identical reported margins, so both are pushed equally by sales. A cause-and-effect view later shows one family runs in long, simple batches while the other needs frequent changeovers, short runs and heavy quality checking. The true cost gap between them is wide enough that one family was comfortably profitable and the other was near break-even or below. Traditional, average-based costing has been shown in academic work to misstate costs by roughly 30 to 46 percent; this is what that error looks like on the factory floor. Figures illustrative; the distortion range is cited from published studies (IJISR/SSR).
The next move is Stage 3: stop averaging the indirect cost and start tracing it by genuine cause and effect. This is the step into activity-based and, better, time-driven activity-based costing, where the resources each output actually consumes are measured rather than assumed. It is the single most valuable rung on the ladder, because it is where the cross-subsidies finally become visible.
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