Cross subsidies in overhead application

The problem with conventional costing in multiproduct manufacturing is that volume-related allocation bases used to apply overhead to products fail to correspond with the unique resource demands of each of a firm's many products. This paper compares overhead applied in a conventional cost system with that applied in a two-stage, activity-based system to illustrate how cross-subsidies occur (where a high-volume product subsidizes a low-volume and complex product). The sensitivity of cross-subsidies to volume and product diversity is addressed. Both volume diversity and product diversity distort product costs in conventional costing; whereas, activity-based costing generally provides more accurate costs. The paper also shows that in conventional cost systems, departmental overhead rates do not necessarily yield more accurate product costs than plant-wide rates. The conditions necessary for advantageous use of departmental rates are discussed. In addition, cost behavior analysis and the dual rate method, both subjects of managerial accounting for decades, can be applied to function as a two-stage, activity-based cost system.