Peanut-butter costing is one of the methods of assigning indirect/overhead costs. Under this method, the organization assigns costs based on broad averages rather than in a proper and targeted manner. This costing method gets its name the way peanut butter is spread on a slice of bread.
Generally, we spread the butter uniformly on a piece of bread without giving much thought if any particular area has got more or less butter. Similarly, under peanut-butter costing, we assign overhead costs uniformly without worrying about how much cost is applied to any particular cost object.
Under the peanut-butter method or traditional costing, a manager usually assigns overhead/indirect costs based on cost driver volume. One example could be the number of machine hours to manufacture a particular item.
Drawbacks of Peanut-Butter Costing
One big drawback of this method is that one may overapply or underapply overhead costs to the cost objects. It results in getting the cost of the product that is either higher or lower than the actual cost. For instance, if a manager applies less overhead, then the cost could get lower.
On the other hand, if a manager applies too much cost, then management may increase the selling price of the product to cover the cost. It, in turn, could lead to fewer sales and loss of market share.
Also, this method of costing does not consider how much resources do different costs objects consume. Again, it could result in inaccurate cost data, which could push management to make unfavorable marketing and operations decisions.
Another drawback of this method is that it fails to allocate non-manufacturing costs that are related to production.
Activity-Based Costing (ABC)
A company can use this costing method to overcome the drawbacks of the peanut-butter costing method. ABC method is the opposite of the peanut-butter method. Under the ABC method, a manager identifies the business activities that lead to cost and assigns costs to those very business activities. Then, based on the activity usage, the manager applies the cost of the activities to the cost objects. Such a method results in a more accurate allocation of costs.
Since ABC assigns costs to the activities that use the overhead and to the product that uses those activities, it gives a more accurate cost picture. Moreover, if a product does not consume a particular cost, then that is not assigned.
Assume that you are a supplier of bakery items and have five clients. The clients give orders daily. So, you have to invoice, package, and deliver daily. Two of the clients often make last-minute changes to order, resulting in you changing the invoice, packaging, and other things.
You have a manager that does all the order processing. The salary of the manager is $4,000 per month. Under peanut-butter costing, the whole order management setup uses one pool of costs, and that is the salary of the manager.
Thus, the salary of the manager is allocated to the customers. To do this, one can simply divide the annual salary of the manager by the total number of orders served. Assume all five clients give 200 orders each in a year. So, the cost comes out to $48 per order ($48000 / 1000).
In this way, we have spread the salary of the manager (cost) uniformly over the orders (cost object). But does it reflect the real cost, or is it an accurate cost reflection – No. Remember, we said that two customers made last-minute changes to their order. So, for the two customers, the cost would be more.
Thus, a better way is to use the ABC approach. Under peanut butter, there was only one pool of costs, but under ABC, we will have to divide costs into more cost pools, such as invoice generating costs, packaging costs, and more. In this way, customers that make more costs must be allocated more overhead.
Peanut-butter costing suffers from many drawbacks. Despite this, many businesses use this because it is simple to implement and saves time, and is useful where no complex activities or high volumes are involved. However, it may not give accurate results. Thus, experts will never recommend using this method.