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	$	464,000			$	249,600			$	91,000			$	35,175			$	839,775
Less:
Materials		281,000				164,000				62,160				27,225				534,385
Direct labor		38,500				17,500				5,600				1,200				62,800
Fringe benefits on direct labor		15,400				7,000				2,240				480				25,120
Indirect costs (@260% of direct labor)		100,100				45,500				14,560				3,120				163,280
Gross margin	$	29,000			$	15,600			$	6,440			$	3,150			$	54,190
Return on sales (see note [a])		6.3	%			6.3	%			7.1	%			9.0	%			6.5	%
Volume		145,000				78,000				28,000				10,500				261,500
Unit price	$	3.20			$	3.20			$	3.25			$	3.35			$	3.21
Unit cost	$	3.00			$	3.00			$	3.02			$	3.05			$	3.00

^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	$	62,800
Fringe benefits on indirect labor		25,120
Information technology		46,160
Machinery depreciation		17,500
Machinery maintenance		7,800
Energy		3,900
Total	$	163,280

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 $46,160 was allocated to the cola bottling line. 80 percent of this $46,160 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 52,300 hours of productive time.

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

• Setups: 1,130 labor-hours for setups.
• Production runs: 585 production runs.
• Number of products: 4 products.
• Machine-hour capacity: 52,300 hours.

  

Diet cola used 390 setup hours, 230 production runs, and 14,500 machine-hours to produce 145,000 units. Regular cola used 155 setup hours, 125 production runs, and 7,800 machine-hours to produce 78,000 units. Cherry cola used 430 setup hours, 125 production runs, and 2,800 machine-hours to produce 28,000 units. Grape cola used 155 setup hours, 105 production runs,and 1,050 machine-hours to produce 10,500 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. (Round cost driver rates to 3 decimal places and other intermediate calculations to nearest whole dollar value. Round cost per unit answers to 2 decimal places.)

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 26,150 hours of machine time to make 261,500 units. (Recall that the machine capacity in this case is 52,300 hours, while Diet, Regular, Cherry, and Grape consume only 26,150 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. (Do not round intermediate calculations. Round "Per unit" to 5 decimal places.)

Answer 1

Lets us first identify cost drivers and calculate cost driver rate.

The production process is broken down into 4 activities: These are the cost drivers
1. Setting up production runs
2. Managing production runs
3. Managing products
4. Operating machinery

Cost driver volumes
1. Setting up production run: 1,130 labour hours
2. Production runs: 585
3. No. of products: 4
4. Machine hour capacity: 52,300

Indirect cost break up and allocation

Cost	Allocation	Amount
Indirect Labour	1. 50% set up machinery 2. 40% set up and manage production run 3. 10% no. of products	1. 62,800* 50% = 31,400 2. 62,800*40% = 25,120 3. 62,800*10% = 6,280
Fringe benefits for indirect labour	40% labour cost
IT	1. 80% scheduling production runs 2. 20% no. of products	1. 46,160 * 80% = 36,928 2. 46,160* 20% = 9232
Machine depreciation,maintenance and energy	Total 29,200 towards machine capacity

Indirect labour rate
1. Cost to set up machinery = 31,400 = 27.787 per hour
Set up hours 1,130

2. Cost to manage production run = 25,120 = 42.94 per run
No. of production runs 585

3. Cost of maintaining record = 6280 = 1570 per product
No. of products 4

IT rate
1. Cost of sceduling runs = 36,928 = 63.125 per run
No. of production runs 585

2. Cost of keeping records = 9232 = 2308 per product
No. of products 4

Machine hour rate = 29,200 / 52,300 = 0.558 per hour
Total Set up hour rate = 27.787 per hour
Total production run rate = 42.94 + 63.125 = 106.065 per run
Maintaining records = 1570+2308 = 3878 per product

Product wise allocation of cost driver elements

Product	Set up	Production run	Machine hours	Units
Diet	390	230	14,500	145,000
Regular Cola	155	125	7,800	78,000
Cherry	430	125	2800	28,000
Grape	155	105	1050	10,500

Indirect cost allocation
Diet Coke: (390 hrs*27.787)+(230*106.065)+(14500 hrs*0.558)+ 3878 = 47,200.88
Regukar Coke: (155*27.787)+(125*106.065)+(7800*0.558)+3878 = 25,795.51
Cherry Coke: (430*27.787)+(125*106.065)+(2800*0.558)+3878 = 30,646.935
Grape Coke: (155*27.787)+(105*106.065)+(1050*0.558)+3878 = 19,907.71

a) Computation of Unit cost

	Diet	Regular	Cherry	Grape
Sales	464,000	249,600	91,000	35,175
Materials	281,000	164,000	62,160	27,225
Direct Labour	38,500	17,500	5600	1200
Fringe benefits on diret labour	15,400	7000	2240	480
Indirect Cost	47201	25,796	30,647	19,908
Gross Margin (Sales- cost)	81,899	35,304	(9,647)	(13.638)
Return on sales (Gross margin/sales)	17.65%	14.14%	-10.6%	-38.77%
Volume	145,000	78,000	28,000	10,500
Price per unit	3.20	3.20	3.25	3.35
Cost per unit (Total cost / volume)	2.63	2.75	3.59	4.65

b) unused capacity workings

No. of machine hours unused= 52,300 - (14,500+7,800+2800+1050) = 26,150 hours
Cost of unused capacity = 26,150*0.558 = 14,592

c) Cost of Vanilla Cola

	Total
Materials	281,000
Direct Labour	38,500
Fringe benefits	15,400
Indirect cost (47201-8091+14592)	53,702
Total Cost	388,602
Volume	261,500
Cost per unit	1.48605

for indirect cost I took the indirect cost of Diet cola as calculated above, reduced machine cost (14,500*0.558) and added cost of unused capacity machine.