Implementing Activity-Based Costing

The case of a juice company

The juice company is a medium-sized company producing four different flavors of juice, including two new flavors recently added on the ground they were in high demand by customers who were willing to pay a premium for them.
Recently, under the pressure of shareholders about the poor financial performance, Grace Orland, manager of the juice company, has been concerned over the erosion of the recent financial results especially for the standard flavors (A and B) which used to earn a 20 per cent of profit margin.
Richard Dunn, the manufacturing manager, was also excited to introduce the new flavors since they were expected to generate higher margins while using the same technology as standard flavors.
However, he noticed that the introduction of new flavors added some technical complexities to the production process. For instance, unlike Flavors A & B, which were produced in huge volume and in long production runs, difficulties started to arise with the new flavors which were produced in smaller batches but required more changeovers and more production runs (see Exhibit 3).
The juice company produced the different flavors in the same factory. Each flavor had a bill of materials that tracks the direct materials consumed by each flavor. Additionally, a cost sheet was used to track the direct labor expenses incurred at each operating step for each of the four flavors. All overhead costs were grouped at the plant level and arbitrarily allocated to each flavor based on direct labor cost. The rate was set at 400 % of direct labor costs (see Exhibit 2).

Grace was intrigued by the behavior of their main competitors who were more interested in competing in, what appears according to the company’s current costing system, to be low profit margin flavors (A and B) than in high profit margins (Flavors C &D). Such behavior has led the manager to question the accuracy of that costing system and to conclude that the current method of allocation of indirect costs may be distorting their product costs thereby causing inappropriate pricing.
The manager hires you as a cost accounting trainee to investigate the root causes of the cost distortion and come up with actions and initiatives to address these issues. Grace promised to provide you with all the information you may need in your undertakings.
Based on the topics you covered in your cost accounting class, you thought that Activity-Based Costing (ABC) may represent a strong tool to tackle the problem.
To remedy the distortions caused by the traditional method of costing based on one single cost pool of indirect costs, you decided to implement Activity-based costing (ABC) method which focuses on the activities, how they are performed, and the resources they consumed and to assign activities costs to products based on how much demand each of these products puts on these activities. After careful analysis of the company’s operations, you identified four main activities: process production run, set up equipment, manage products, and run machines. The demand on these activities by different flavors is illustrated in Exhibit 3.

You began by identifying the resources that were being consumed by activities. These resources were grouped in six categories as shown in Exhibit 1.
After interviewing the department heads in charge of support staff wages and benefits and insurance, you found out that their services are used by three activities: process production run (40%), set up (40%), and the remaining 20 % consumed to manage products.
Next, you tackled the information system item and determines, after interview with the head of the information system department, that process production runs accounts for 30 % of their services while 70 % are used to manage products.
The results of your investigations about the usage of the equipment revealed that it was entirely used to run machines. Maintenance services were shared equally between the production run activity and run machine activity. Finally, utility was shared equally by the four activities.

Questions

1. Describe the problem the company is facing
2. Calculate the costs for the four flavors using ABC
3. Explain why, in this case, the ABC results are different from those calculated under the traditional method based one single cost pool of indirect costs and provide specific examples from the case that support your analysis. Be as much specific as you can.
4. What are the opportunities for cost reduction you may suggest to Grace?

Exhibit 1
Resources Used Costs of Resources

Support staff wages $ 30,000
Benefits and insurances 12,000
Information Systems 10,000
Equipment 7,000
Maintenance 4,000
Utilities 3,000
Total $ 66,000

Exhibit 2: Traditional Income Statement
Flavor A Flavor B Flavor C Flavor D Total
Sales $ 86,000.00 $ 52,000 $ 16,000 $ 3,600 $ 157,600.00
Direct Material costs 28000 20000 5500 400 53900
Direct labor costs 9500 5000 1500 500 16500
Overhead costs at 400% of Direct labor
costs

38000

20000

6000

2000

66000
Operating Income $ 10,500 $ 7,000 $ 3,000.00 $ 700.00 $ 21,200.00
Profit margin 12% 13% 19% 19% 13%

Exhibit 3: direct costs and activity cost drivers
Flavor A Flavor B Flavor C Flavor D Total
Sales in units 60,000 50,000 10,000 2,000 122,000
Sales in Dollars $ 86,000.00 $ 52,000 $ 16,000 $ 3,600 $ 157,600.00
Unit selling price $ 1.43 $ 1.04 $ 1.60 $ 1.80
Machine hours per unit 0.1 0.1 0.1 0.1 12200
Production runs 50 50 38 12 150
Set up times (hours) 150 120 200 100 570
Manage products 1 1 1 1 4