Question

Howard Rockness was worried. His company, Rockness Bottling, showed declining profits over the past several years despite an increase in revenues. With profits declining and revenues increasing, Rockness knew there must be a problem with costs.

Rockness sent an e-mail to his executive team under the subject heading, “How do we get Rockness Bottling back on track?” Meeting in Rockness’s spacious office, the team began brainstorming solutions to the declining profits problem. Some members of the team wanted to add products. (These were marketing people.) Some wanted to fire the least efficient workers. (These were finance people.) Some wanted to empower the workers. (These people worked in the human resources department.) And some people wanted to install a new computer system. (It should be obvious who these people were.)

Rockness listened patiently. When all participants had made their cases, Rockness said, “We made money when we were a smaller, simpler company. We have grown, added new product lines, and added new products to old product lines. Now we are going downhill. What’s wrong with this picture?”

Rockness continued, “Here, look at this report. This is last month’s report on the cola bottling line. What do you see here?” He handed copies of the following report to the people assembled in his office.

Monthly Report on Cola Bottling Line
	Diet				Regular				Cherry				Grape				Total
Sales	$	142,500			$	95,000			$	27,300			$	7,175			$	271,975
Less:
Materials		50,000				38,000				11,480				3,975				103,455
Direct labor		17,500				10,500				2,800				450				31,250
Fringe benefits on direct labor		7,000				4,200				1,120				180				12,500
Indirect costs (@260% of direct labor)		45,500				27,300				7,280				1,170				81,250
Gross margin	$	22,500			$	15,000			$	4,620			$	1,400			$	43,520
Return on sales (see note [a])		15.8	%			15.8	%			16.9	%			19.5	%			16.0	%
Volume		75,000				50,000				14,000				3,500				142,500
Unit price	$	1.90			$	1.90			$	1.95			$	2.05			$	1.91
Unit cost	$	1.60			$	1.60			$	1.62			$	1.65			$	1.60

^a Return on sales before considering selling, general and administrative expenses.

Rockness asked, “Do you see any problems here? Should we drop any of these products? Should we reprice any of these products?” The room was silent for a moment, and then everybody started talking at once. Nobody could see any problems based on the data in the report, but they all made suggestions to Rockness ranging from “add another cola product” to “cut costs across the board” to “we need a new computer system so that managers can get this information more quickly.” A not-so-patient Rockness stopped the discussion abruptly and adjourned the meeting.

He then turned to the quietest person in the room—his son, Rocky—and said, “I am suspicious of these cost data, Rocky. Here we are assigning indirect costs to these products using a 260 percent rate. I really wonder whether that rate is accurate for all products. I want you to dig into the indirect cost data, figure out what drives those costs, and see whether you can give me more accurate cost numbers for these products.”

Rocky first learned from production that the process required four activities: (1) setting up production runs, (2) managing production runs, and (3) managing products. The fourth activity did not require labor; it was simply the operation of machinery. Next, he went to the accounting records to get a breakdown of indirect costs. Here is what he found:

Indirect labor	$	31,250
Fringe benefits on indirect labor		12,500
Information technology		19,500
Machinery depreciation		10,500
Machinery maintenance		5,000
Energy		2,500
Total	$	81,250

Then, he began a series of interviews with department heads to see how to assign these costs to cost pools. He found that 40 percent of indirect labor was for scheduling or for handling production runs, including purchasing, preparing the production run, releasing materials for the production run, and performing a first-time inspection of the run. Another 50 percent of indirect labor was used to set up machinery to produce a particular product. The remaining 10 percent of indirect labor was spent maintaining records for each of the four products, monitoring the supply of raw materials required for each product, and improving the production processes for each product. This 10 percent of indirect labor was assigned to the cost driver “number of products.”

Interviews with people in the information technology department indicated that $19,500 was allocated to the cola bottling line. 80 percent of this $19,500 information technology cost was for scheduling production runs. 20 percent of the cost was for record keeping for each of the four products.

Fringe benefits were 40 percent of labor costs. The rest of the overhead was used to supply machine capacity of 28,500 hours of productive time.

Rocky then found the following cost driver volumes from interviews with production personnel.

• Setups: 710 labor-hours for setups.
• Production runs: 235 production runs.
• Number of products: 4 products.
• Machine-hour capacity: 28,500 hours.

  

Diet cola used 250 setup hours, 90 production runs, and 7,500 machine-hours to produce 75,000 units. Regular cola used 85 setup hours, 55 production runs, and 5,000 machine-hours to produce 50,000 units. Cherry cola used 290 setup hours, 55 production runs, and 1,400 machine-hours to produce 14,000 units. Grape cola used 85 setup hours, 35 production runs,and 350 machine-hours to produce 3,500 units. Rocky learned that the production people had a difficult time getting the taste just right for the Cherry and Grape colas, so these products required more time per setup than either the Diet or Regular colas.

Required:

a. Recompute the unit costs for each of the cola products: Diet, Regular, Cherry, and Grape.

b. What is the cost of unused capacity?

c. Now assume that Rockness is considering producing a fifth product: Vanilla cola. Because Vanilla cola is in high demand in Rockness Bottling’s market, assume that it would use 14,250 hours of machine time to make 142,500 units. (Recall that the machine capacity in this case is 28,500 hours, while Diet, Regular, Cherry, and Grape consume only 14,250 hours.) Vanilla cola’s per unit costs would be identical to those of Diet cola except for the machine usage costs. What would be the cost of Vanilla cola? Calculate on a per-unit basis, and then in total.

Answer 1

Assumption: Fixed Machine Costs are not allocated as fixed in nature. Further, on the basis of Machine Capacity instead of Operation Activity students may opt to allocate.