Direct costing with broad overhead: the stage where distortion begins.

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.

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 spreads overhead by volume, so it understates the cost of complex, low-volume work; this is what that error looks like on the factory floor. Figures illustrative.