What typically causes cost distortion?

Cost distortion generally occurs when expenses are not accurately assigned to the products or services that incur them. An inadequate allocation system that fails to effectively capture different types of manufacturing overhead (MOH) is a fundamental source of this issue.

In manufacturing environments, overhead costs can vary significantly depending on the nature of production processes, including factors like machine maintenance, utilities, and indirect labor. When such costs are not properly assigned based on the actual consumption of resources by different products, it leads to some products being over-costed while others are under-costed. This misallocation can result in misleading financial reports, inappropriate pricing strategies, and ultimately, poor business decisions.

For instance, if a company produces multiple products that utilize different amounts and types of overhead, but the allocation system uses a single average rate for all products, it can cause cost distortion. As a result, one product may bear too much of the overhead burden, reflecting a higher cost than warranted, while another product benefiting from less overhead may appear to be more profitable than it actually is. Hence, an effective allocation system is critical for providing accurate cost data which is essential for pricing and profitability analysis.