Question

Creamy Creations Pty Ltd manufactures a wide range of delicious cakes and pastries. At the annual Christmas party, the company’s Chairman, Robert Cole, treated his employees to a nostalgic review of the firm’s history. He told them: Twenty years ago we had only three product lines—pies, finger buns and lamingtons. We were flat out producing large volumes of each product, using very simple machinery and a lot of hard work. Oh My! How Things Have Changed! We still make and sell a lot of pies and lamingtons, but we also produce a wide range of low-volume lines, such as Danish pastries, doughnuts and vanilla slices. I hear you sighing, and no wonder; these low-volume products are a pain in the neck. They are complex to produce and their short production runs involve a lot of extra machinery setups and material handling. But the accountants tell me that these speciality lines have wonderful profit margins, so we must not complain. Robert then outlined the dramatic changes that had occurred within the business over the past 20 years. In the factory he had seen the introduction of computer-controlled mixing machines and ovens that replaced a lot of the direct labour operations, and an increased emphasis on quality and delivery performance. Indeed, right across the business, more and more effort had been placed on keeping the customer happy. However, his speech cast a gloomy shadow across the Christmas festivities when he warned: Despite all this progress, the company seems to be struggling. Our profits are declining, and if things don’t improve over the next few months, this may be our last Christmas together. To survive we must all work very hard. We must focus on increasing sales, particularly of our high-margin speciality products. The company’s management accountant, Pamela Lou, had become concerned about the conventional product costing system at Creamy Creations. The manufacturing people were also sure that the costing system was distorting product costs. Required: 1. Describe the changes in cost structure that are likely to have occurred at Creamy Creations Pty Limited over the last 20 years and explain their causes. 2. Do you think that the existing costing system understates or overstates the cost of: (a) Lamingtons (b) Danish pastries? Explain your answers. 3. Pamela Lou, the management accountant for Creamy Creations Pty Limited has recommended the introduction of an activity-based costing system to improve the accuracy of the company’s product costs. Pamela is filled with enthusiasm, but the company’s Chairman, Robert Cole is more cautious. Prepare a report for Robert Cole that outlines the benefits, costs and limitations of activity-based costing. (To set your report in the appropriate business context, you should refer to the information given above)

Answer 1

(1): Over the last 20 years ‘overheads’ for the company must have increased. Overheads are those expenses that relate to the day to day running of the business. They are not operating expenses and hence cannot be tied or traced to a specific product line or a business unit. As the company grew and introduced new products like Danish pastries, doughnuts and vanilla slices its overheads must also have increased, besides an increase in its operating costs on an absolute basis.

(2): The existing costing system is overstating the cost of lamingtons and understating the cost of Danish pastries. This is because in the conventional costing system all indirect costs are allocated to different items on the basis of volume of that item i.e. number of units produced. There is a faulty assumption that number of units produced is the underlying cause of factory overhead. As the number of units produced is more for lamingtons then more costs will be allocated to it and hence its costs will be overstated. The opposite is true in case of Danish Pastries.

(3): Report for Robert Cole:

Activity based costing (ABC) is that method of costing in which overheads and other indirect costs will be allocated to our different items like lamingtons, pastries etc. on the basis of some activity. The activity is a cost driver and hence ABC allocates costs in a logical manner. In the ABC method costs are first assigned to those activities that are the real cause of the overhead. Then cost of these activities is allocated to the products in proportion to their use of these activities.

The advantage of ABC is that it will give accurate product costs. In other words we will be able to determine exact cost of each of our product line like lamingtons, doughnuts, pastries etc. The cost data for each of our product line will be accurate and reliable. Secondly we will be able to identify the real nature of cost behavior and identify activities that do not add value. In terms of disadvantages the costs associated with managing the ABC system is high. This is because ABC creates several cost pools and this leads to formation of a complex system. Secondly activity cost rates will have to be updated regularly and this will cause measurement difficulties in future.