Question

Implementation of Activity-based costing (ABC) The case of a Juice Company John Orland, controller of the Juice Company, has been concerned over the erosion of the recent financial results especially for the standard flavors (A and B) which used to earn a hefty 20 per cent of profit margin.

Recently, Dan Brun, the sales manager has expanded the lines of products to encompass new flavors (B & C) which were in high demand by customers who were willing to pay 5 to 10 % premium.

Richard Dunn, the manufacturing manager, was also excited to introduce the new flavors since they were expected to generate higher margins while using the same technology as standard flavors. However, he noticed that the introduction of new flavors added some technical complexities to the production process. For instance, unlike Flavors A & B, which were produced in huge volume and in long production runs, difficulties started to arise with the new flavors which were produced in smaller batches but required more changeovers and more production runs (see Exhibit 3).

The Juice Company produced the different flavors in the same factory. Each flavor had a bill of materials that determines the quantity and cost of direct materials used for the production of each flavor. Additionally, a cost sheet was used to track the direct labor expenses incurred at each operating step for each of the four flavors. All overhead costs were grouped at the plant level and allocated to each flavor on the basis of direct labor cost. The rate was set at 400 % of direct labor costs (see Exhibit 2).

John was intrigued by the behavior of their main competitors who were more interested in competing in, what appears according to the company’s current costing system, to be low profit margin flavors (A and B) than in high profit margins (Flavors C &D). Such behavior has led the controller to question the accuracy of that costing system and to conclude that the current method of allocation of indirect costs is distorting their product costs thereby causing inappropriate pricing.

To remedy the distortions caused by the traditional method of costing based on one single cost pool of indirect costs, John decided to implement Activity-based costing (ABC) method which focuses on the activities, how they are performed, and the resources they consumed and to assign activities costs to products based on how much demand each of these products puts on these activities. After careful analysis of the company’s operations, the controller identified four main activities: process production run, set up equipment, manage products, and run machines. The demand on these activities by different flavors is illustrated in Exhibit 3.

He began by identifying the resources that were being consumed by activities. These resources were grouped in six categories as shown in Exhibit 1. 2

After interviewing the department heads in charge of support staff wages and benefits and insurance, he found out that their services are used by three activities: process production run (40%), set up (40%), and the remaining 20 % consumed to manage products.

Next, the controller tackled the information system item and determines, after interview with the head of the information system department, that process production runs accounts for 30 % of their services while 70 % are used to manage products.

The results of his investigations about the usage of the equipment revealed that it was entirely used to run machines. Maintenance services were shared equally between the production run activity and run machine activity. Finally, utility was shared equally by the four activities.

Questions

1. Describe the problem the company is facing

. Calculate the costs for the four favors using ABC

3. Explain why, in this case, the ABC costs are different from those calculated under the traditional method based one single cost pool of indirect costs and provide examples from the case that support your analysis.

4. What would you do as a manager?

Exhibit 1

Exhibit 1 Resources Used Costs of Resources

Support staff wages $ 30,000

Benefits and insurances 12,000

Information Systems 10,000

Equipment 7,000

Maintenance 4,000

Utilities 3,000

Total $ 66,000

Exhibit 2:

Traditional Income Statement

Flavor A Flavor B Flavor C Flavor D Total

Sales $ 86,000.00 $ 52,000 $ 16,000 $ 3,600 $157,600.00

Direct Material costs 28000 20000 5500 400 53900

Direct labor costs 9500 5000 1500 500 16500

Overhead costs at 400%

of Direct labor costs 38000 20000 6000 2000 66000

Operating Income $10,500.00 $7,000.00 $ 3,000.00 $ 700.00 $ 21,200.00

Profit margin 12% 13% 19% 19% 13%

Exibit 3: direct costs and and activity cost drivers

Flavor A Flavor B Flavor C Flavor D Total

Sales in units 60,000 50,000 10,000 2,000 122,000

Sales in Dlollars $ 86,000.00 $ 52,000 $ 16,000 $ 3,600 $ 157,600.00

Unit selling price $ 1.43 $ 1.04 $ 1.60 $ 1.80

Machine hours per unit 0.1    0.1 0.1 0.1 12200

Production runs 50 50 38 12 150

Set up times ( hours) 150 120 200 100 570

Manage products 1 1 1 1 4

Answer 1

1. The company is ideally facing the problem of choice. The company in order to take a decision on production of goods requires to know the best profitability combination possible, so that the company can stay in the market amidst competition.

2.

	Setup costs
	40% of support staff wages	=30000*40%	12,000
	40% benefits and insurance	=12000*40%	4,800
	Total Setup costs in $		16,800
	Production Run
	40% of support staff wages	=30000*40%	12,000
	40% benefits and insurance	=12000*40%	4,800
	30% Information System costs	=10000*30%	3,000
	Total Production Run costs in $		19,800
	Manage Products
	20% of support staff wages	=30000*20%	6,000
	20% benefits and insurance	=12000*20%	2,400
	70% Information System costs	=10000*70%	7,000
	Total Manage costs in $		15,400
	Machining Costs
	Equipment Costs		7,000
	Maintenance Costs		4,000
	Utilities		3,000
	Total Machining Costs in $		14,000
	Particulars	Flavour A	Flavour B	Flavour C	Flavour D	Total
	Sales Units	60000	50000	10000	2000	122000
	Sales in $	86000	52000	16000	3600	157600
	Unit Selling Price	1.43	1.04	1.60	1.80
	Machine Hours per unit	0.1	0.1	0.1	0.1	12200
=>	Machine Hours Required	6000	5000	1000	200	12200
	Machining Costs in $	6,885.25	5,737.70	1,147.54	229.51
	Production Run	50	50	38	12	150
	Production Run Costs in $	6,600	6,600	5,016	1,584
	Set up Time	150	120	200	100	570
	Set up Time Costs in $	4,421	3,537	5,895	2,947
	Manage Product	1	1	1	1	4
	Manage Product Costs in $	3,850	3,850	3,850	3,850
	As per ABC Costing method					Amt in $
	Particulars	Flavour A	Flavour B	Flavour C	Flavour D	Total
	Sales	86,000	52,000	16,000	3,600	1,57,600
	DM Costs	28,000	20,000	5,500	400	53,900
	DL Costs	9,500	5,000	1,500	500	16,500
	Overheads
	Machining Costs in $	6,885	5,738	1,148	230	14,000
	Production Run Costs in $	6,600	6,600	5,016	1,584	19,800
	Set up Time Costs in $	4,421	3,537	5,895	2,947	16,800
	Manage Product Costs in $	3,850	3,850	3,850	3,850	15,400
	Operating Income	26,744	7,275	-6,908	-5,911	21,200

3.Under the traditional costing method, the overheads are first allocated and apportioned to various production departments and service departments. Under the ABC method of costing, the cost of each activity is separately calculated and apportioned basis the identified cost object. The ABC method of costing is an accurate system of costing as there is clear cause effect relationship on the distribution of the costs. This is evident from the above cost computations also.

4. As the manager of the company, based on the ABC costing, the order of preference for production woll be Flavour A followed by Flavour B followed by Flavour D and flavour C respectively.

Even though the margins are low in A and B the profitability of these 2 products are high compared to those of C and D.