Question

Niagara Winery makes two different grades of wine—regular wines and specialty wines. Recently, Niagara has shown small profits on its regular wines and large profits on its specialty wines. As a result, management is considering getting out of the regular wine business and concentrating on specialty wines. This is a difficult decision because Niagara had been very profitable in regular wines, its original business. In fact, the profitability of regular wines dipped sub- stantially only after Niagara got into the specialty wine business. Before making a decision, Niagara wants to be sure that it understands what it costs to make and sell the regular and specialty wines. This question focuses on costs in the distribution area.

Niagara distributes the regular wines and the specialty wines through completely different distribu- tion channels. It distributes 120,000 cases of the regular wines through 10 provincial distributors and 80,000 cases of the specialty wines through 30 specialty distributors. Niagara incurs $2,636,000 in distribution costs. Under its existing costing system, Niagara allocates distribution costs to products based on cases shipped.

To understand better the demands on its resources in the distribution area, Niagara identifies three activities and related activity costs:

1. Promotional activity including advertising and point-of-sale material at each distributor. Niagara esti- mates it incurs $9,600 per distributor.

2. Orderhandlingcostsincludingcoststoconfirmandinputtheorderintotheorder-entrysystem,setaside the correct number of cases, organize shipment and delivery, verify order packing, ensure delivery, send invoices, and follow up for payments. Niagara estimates costs of $360 for performing all the activities pertaining to each order. Niagara’s records show that distributors of regular wine placed an average of 10 orders per year, while distributors of specialty wine placed an average of 20 orders per year.

3. Distribution costs of $10 per case for freight.

.

Required
1. Calculate the total distribution costs and distribution cost per case for the regular wine and the spe- cialty wine using Niagara’s existing costing system.

2. a. For each activity, classify the cost of the activity as an output unit-level, batch-level, product-sus- taining, service-sustaining, or facility-sustaining cost. Explain your answers.
b. Calculate the total distribution costs and distribution cost per case for the regular wine and the spe- cialty wine using Niagara’s activity-based costing (ABC) system.
3. Explain the cost differences and the accuracy of the product costs calculated using the existing and the ABC systems. How migh

Answer 1

1. Given,

Total distribution costs= $2,636,000

cases of regular wine = 120,000

cases of specialty wine shipped = 80,000

Distribution cost per case= Total distribution cost/ total cases of regular and specialty wine

= 2,636,000/120,000+80,000= $13.18 per case

total distribution costs for regular wine= 13.18 * 120,000= $1,581,600

distribution cost per case for the regular wine= $13.18

total distribution costs for specialty wine= 13.18 * 80,000= $1,054,400

distribution cost per case for the specialty wine= $13.18

2.a- As per data given, Niagara identifies three activities and related activity costs:

Promotional activity: It includes advertising and point-of-sale material at each distributor and is estimated at $9,600 per distributor. It is a product sustaining cost. It is not related to no. of cases shipped and is a distributor-level costs incurred to promote the product amongst the distributors.

Order handling costs: It includes costs to confirm and input the order into the order-entry system. These are batch level costs as happen each time a customer places an order no matter how many no. of cases ordered. Niagara estimates costs of $360 for performing all the activities.

Distribution costs: It is unit level cost as $10 per case is spent for freight.

2.b.

As per Activity -based cost system, we will consider all activities costs as mentioned in 2a for total distribution cost calculations

i) Distribution cost of freight:

$10 per case is incurred for freight

For regular wine: $10 * 120,000 cases = $1,200,000

For specialty wine: $10 * 80,000 cases= $800,000

ii) Order handling cost:

$360 is spent on all activities pertaining to order

For Regular wine: Given, Distributors= 10, 10 orders per year

Order cost for regular wine= $360 * 10 orders/year * 10 = $36,000

cost per case for the regular wine= $36000/$120,000= 0.30

For specialty wine: Given, Distributors= 30, 20 orders per year

Order cost for specialty wine= $360 * 20 orders/year * 30 = $216,000

cost per case for the specialty wine= $216000/$80,000= 2.70

iii) Promotion costs:

For regular wine: 9600*10= $96,000

cost per case for the regular wine= $96000/$120,000= 0.80

For specialty wine: 9600*30= $288,000

cost per case for the specialty wine= $288,000/$80,000 = 3.60

Total distribution costs for regular wine= $1,200,000 + $36,000+ $96,000= $1,332,000

Total cost per case for regular wine=10+0.30+0.80= $11.10

Total distribution costs for specialty wine= $800,000+ $216,000+$288,000= $1,304,000

Total cost per case for specialty wine= 10+2.70+3.60= $16.30

3. According to the existing costing system only cases shipped is being used as a base to allocate costs for distribution costs. Because of which the distribution cost per case is equal for specialty and regular wines i.e. $13.18. But in reality, specialty wines utilize distribution resources more and hence cost incurred should be more for them than regular wines:

i. Cost of promotion is $9,600 for each distributor no matter how many cases sold. Specialty wine distributors sell less cases in comparison to regular wine distributors. Hence the promotional cost per case of wine sold for specialty wines is more than cost incurred for promotions of regular wines.

ii) Ordering cost is $360 independent of the number of cases sold. Since specialty wine distributors order less cases per order, the ordering costs per case are higher than for regular wines. The existing costing system costs the distribution costs less per case for specialty wines and overcosts distribution costs per case for regular wines.

ABC system can help Niagra in doing accurate calculations for costing which will result in a better understanding of pricing structure, identifying activities that incurr heavy cost but do not contribute in output, in cost-reduction, planning and managing activities resourcefully.