Question

Soap Makers International

Several years ago, Ingrid Krause wanted some international expertise and applied for a transfer to her company’s soap division, which is located south of Warsaw, Poland. The soap division manufactures hand soap for use in a large number of settings, from hospitals to luxury hotels. Ingrid was awarded the transfer to the soap division and was assigned to the accounting department. She is responsible for overseeing the costing and probability analysis of the various soaps and soap-making processes. During her tenure in the soap division, there were numerous changes in the number of soaps manufactured and the processes to make the different soaps. Consequently, Ingrid’s position required her to consider changes in the accounting processes to reflect the changes in the soap division’s business.

For several decades, the company’s soap-making process required a large labour force that manufactured and packaged the soap mainly by hand. Local economic changes meant that the labour force that the factory required was not as available as it had been in the past. As a result, the division was experiencing slower processing time, and more snap being rejected during inspections because of quality concerns. To address the issues related to the lack of labour availability, the division’s management decided three years ago that automation was the way to go. Consequently, over the last three years, the soap making processes have changed with the implementation of automation.

The automation of the soap making processes have allowed for a much larger variety of soap and packing, a reduced direct labour force and direct labour costs, and a higher level of traceability of costs to the various soaps because of technological improvements. Soaps made for industrial applications require different ingredients, less time in processing, less time in finishing, and less time in and cheaper packaging than do soaps for the hotel industry. The costs of materials and packaging are directly traceable to the various types of soaps through new software that uses bar codes and counters to trace material costs to the various soaps directly.

Ingrid feels that the current costing system should be revisited. The cost driver for allocation of the overhead costs (such as supervisory salaries and plant utilities) have always been direct labour hours cost. However, given the decline in the use of labour due to automation, Ingrid is questioning its suitability as a basis of allocation. Ingrid would like to explore activity based costing to allocate overhead costs.

Ingrid has gathered cost data for two representative soaps: one sold to hospitals and one sold to hotels. Further, Ingrid has gathered data from the automated system on the amount of time each type of soap spends in the three manufacturing processes: processing, finishing, and packaging. The soap is produced in large batches, consequently, the data are adjusted to reflect the average cost per 100g of soap. The data for type of soap for one month’s production are in Exhibit 1.

REQUIRED

1. Calculate the costs (of direct material, direct labour, and overhead) for each of the two representative types of soap using direct labour as the basis for the allocation of overhead.

EXHIBIT 1 – COSTS FOR ONE MONTH’S PRODUCTION OF SOAP

Cost Components	Total	Costs Per 100 g of soap
		Industrial Soap (Hospital)	Luxury Soap (Hotel)
Direct Materials	$4.000,000	$0.40	$0.80
Packaging	$2,000,000	$0.10	$0.60
Direct Labour	$750,000	$0.14	$0.15
Manufacturing	$5,000,000
Processing	$2,500,000
Finishing	$1,500,000
Packaging	$1,000,000

EXHIBIT 2 – TIME REQUIRED FOR ONE MONTH’S PRODUCTION OF SOAP

Time Components	Total	Time per 100 g of soap
		Industrial Soap (Hospital)	Luxury Soap (Hotel)
Processing	750,000 seconds	0.2 second	0.4 second
Finishing	300,000 seconds	0.03 second	0.4 second
Packaging	100,000 seconds	0.006 second	0.5 second

Answer 1

I Statement showing total costs per unit of Soap

Particulars	Industrial Soap	Luxury Soap
Direct Material	$0.40	$0.80
Packaging	$0.10	$0.60
Direct Labor	$0.14	$0.15
Manufacturing Overheads (Refer working note 1)	$1.91	$8.89
Total Cost per unit	$2.55	$10.44

Working Notes

1.Calculation of Cost Driver rates for overhead costs and overhead cost per unit

Particulars	Processing	Finishing	Packaging	Manufacturing	Total
A.Overhead Costs	$25,00,000	$15,00,000	$10,00,000	$50,00,000
B.Total Time	7,50,000	3,00,000	1,00,000	11,50,000
C.Cost driver rate (A/B)	$3.33	$5	$10	$4.35
D. Industrial soap cycle time	0.2	0.03	0.006	0.236
E. Overhead Cost for Industrial Soap (C*D)	$0.67	$0.15	$0.06	$1.0266	$1.91
F. Luxury Soap cycle time	0.4	0.4	0.5	0.13
G.Overhead Cost per Luxury Soap (C*F)	$1.33	$2	$5	$0.56	$8.89

Notes:

1. Activity based costing assigns overhead costs to products in a logical manner compared to the conventional method of absorbing costs to the products using a single cost driver such as direct labor hours and machine hours.
2. Activity based costing seeks to analyse the cause and effect relationship for the cost and the corresponding activity for the creation of such cost, the method identifies activities in an organisation and assigns the cost of each activity to all the products and services according to the actual consumption by each.
3. In the above scenario the soap manufacturing unit has identified different activities i.e processing, finishing, secondary packaging etc. The costs are first pooled to these activities and these costs are then driven to the products by identifying a suitable cost driver, labor hours is chosen as the cost driver in the instant case because it is the number of labor hours that cause or create the overhead cost, similarly number of maintenance hours is the factor that creates the cost of repairs and maintenance of machinery.
4. In the instant case luxury soap appears to be highly priced compared to industrial soap due to the fact that the resources in terms of labor hours per unit for the former is greater than the latter, therefore greater proportion of overhead costs are driven towards luxury soap.