Question

World Gourmet Coffee Company (WGCC) is a distributor and processor of different blends of coffee. The company buys coffee beans from around the world and roasts, blends, and packages them for resale. WGCC currently has 15 different coffees that it offers to gourmet shops in one-pound bags. The major cost is raw materials; however, there is a substantial amount of manufacturing overhead in the predomi-nantly automated roasting and packing process. The company uses relatively little direct labor. Some of the coffees are very popular and sell in large volumes, while a few of the newer blends have very low volumes. WGCC prices its coffee at full product cost, including allocated overhead, plus a markup of 30 percent. If prices for certain coffees are significantly higher than market, adjustments are made. The company competes primarily on the quality of its products, but customers are price-conscious as well. Data for the 20x1 budget include manufacturing overhead of $3,000,000, which has been allocated on the basis of each product’s direct-labor cost. The budgeted direct-labor cost for 20x1 totals $600,000. Based on the sales budget and raw-material budget, purchases and use of raw materials (mostly coffee beans) will total $6,000,000. The expected prime costs for one-pound bags of two of the company’s products are as follows:

KonaMalaysian

Direct material .............................................................................................................................$3.20 $4.20

Direct labor ...................................................................................................................................30 .30

WGCC’s controller believes the traditional product-costing system may be providing misleading cost information. She has developed an analysis of the 20x1 budgeted manufacturing-overhead costs shown in the following chart.

Activity Cost Driver Budgeted Activity Budgeted Cost

Purchasing ................................Purchase orders ........................... 1,158 .....................$ 579,000

Material handling .......................Setups ......................................... 1,800 .....................720,000

Quality control............................Batches ........................................ 720 .....................144,000

Roasting ....................................Roasting hours ..............................96,100 ......................961,000

Blending ....................................Blending hours..............................33,600 ......................336,000

Packaging .................................Packaging hours ...........................26,000 ...................... 260,000

Total manufacturing-overhead cost .......................................................................................................$3,000,000

Data regarding the 20x1 production of Kona and Malaysian coffee are shown in the following table. There will be no raw-material inventory for either of these coffees at the beginning of the year.

KonaMalaysian

Budgeted sales .....................................................................................................2,000 lb. 100,000 lb.

Batch size ............................................................................................................500 lb. 10,000 lb.

Setups .................................................................................................................3 per batch 3 per batch

Purchase order size ..............................................................................................500 lb. 25,000 lb.

Roasting time .......................................................................................................1 hr. per 100 lb. 1 hr. per 100 lb.

Blending time ....................................................................................................... .5 hr. per 100 lb. .5 hr. per 100 lb.

Packaging time ..................................................................................................... .1 hr. per 100 lb. .1 hr. per 100 lb.

Chapter 5 Activity-Based Costing and Management 219 Required:

1. Using WGCC’s current product-costing system:

a. Determine the company’s predetermined overhead rate using direct-labor cost as the single cost driver.

b. Determine the full product costs and selling prices of one pound of Kona coffee and one pound of Malaysian coffee.

2. Develop a new product cost, using an activity-based costing approach, for one pound of Kona coffee and one pound of Malaysian coffee.

3. What are the implications of the activity-based costing system with respect to

a. The use of direct labor as a basis for applying overhead to products?

b. The use of the existing product-costing system as the basis for pricing? (CMA, adapted)

Answer 1

1(a)the company’s predetermined overhead rate using direct-labor cost as the single cost driver.

* Budegeted Sales /Purchase order size = number of orders

= 100000 lbs/25000lbs = 4 orders

3a)Several activities other than direct labor drive overhead are indicated by the ABC analysis. The current system has over cost the high-volume product, Malaysian coffee and significantly has under cost Kona coffee, the low-volume product, as shown by the cost computations.

b)The low-volume products are not covering their share of the cost of those resources though they are using the resources. The ABC cost of Kona blend is $7.46, which is much higher than that of its $6.50 in current system. The long run prices should be set above cost, by the company. It may be acceptable to price some products below full activity-based cost temporarily, if there is excess capacity and many of the costs are fixed, in order to create demand for the product. The high volume and high margined products will subsidize the low margined products otherwise. These are the implications of ABC analysis.