Question

Case: Cost System Considerations for CANADA SNOWCONES LTD.

Canada Snowcones Ltd. (CSL) owned and operated 20 retail frozen yogurt stores spread throughout Southern Ontario, from Toronto to Windsor. CSL's stores sold only high quality, premium frozen yogurt. They offered an assortment of 35 different frozen yogurt flavours. A significant amount of the CSL flavours were special, such as "Peanut Butter Bacon", "Charcoal-Sushi", and "Tropical Cheese Sensations". However, CSL also sold a few of the classic frozen yogurt flavours, such as vanilla, milk chocolate, mint, and other singular fruit flavours. While some of the flavours were very popular, there were also some of the more peculiar flavours that had low total sales in terms of units.

CSL produced its own frozen yogurt. The founder of the company, Samantha Reynolds, had originally made the yogurt in her basement. But eventual growing demand led to Samantha renting part of factory for CSL's production. As CSL grew, Samantha was able to afford automated but more costly production equipment that blended the flavours and packaged the liquid frozen yogurt for freezing. CSL's most significant production costs were for raw materials, particularly yogurt, brown sugar, and the special flavour ingredients, and for the purchase, operation, and maintenance of production equipment.

All of CSL's products had the same retail price, as customers could choose or combine any flavours by scoops. Samantha set the prices to generate, on average, a markup of 100% on average full production costs. CSL's 2019 budget included manufacturing overhead (MOH) of $450,000. To estimate product costs, Samantha spread this MOH cost to products based on a proportion of the direct labour (DL) costs used in the production process. CSL's total DL costs for 2019 was $200,000, so Samantha charged the overhead to products at a rate of MOH to total DL costs.

Last week, Laura Horton, Samantha's babysitter for her daughter and the CEO of a large production firm, advised that Samantha's pricing strategy was not optimal. Laura's insight was that the expenses for producing CSL's numerous flavours were not uniform. She thought those inconsistencies should be reflected in the prices charged, or CSL's earnings would fluctuate as the combination of flavours sold varied.

Laura proposed that Samantha reestimate product costs using activity-based costing. She recommended that Samantha identify the major activities whose costs were included in the company's MOH costs. Then, she should apply these costs to products based on the products consumption of each of those activities. In response to Laura's suggestions, Samantha prepared the information presented below in Table 1.

Samantha decided to hire your consulting firm to help calculate the costs of two demonstrative flavours as an experiment to see if Laura's activity based costing system suggested produced any significant contrasts. She asked Laura to take her best estimate as to where she might find the most material differences, if any existed. After Samantha described the products to her, Laura suggested that she use Peanut Butter Bacon and Chocolate as the test product examples. Table 2 provides data relevant to the two selected products.

Table 1 Activity Purchasing Material Handling Mixing Chilling Packaging Quality Control Total MOH costs Canada Snowcones Ltd. - Budgeted MOH Costs Budgeted Cost (5000) Driver $ 60,000 Purchase Orders $ 71,250 Number of setups $ 91,500 Mixing hours $ 131,250 Chilling hours $ 82,500 Packaging machine hours $ 13,500 Number of batches $ 450,000 Budgeted Activity Level 829 1,766 920 1,856 1,020 205 Table 2 Canada Snowcones Ltd. - Two Product Examples Peanut Butter Bacon Direct Material (DM) $ 2.20 per gallon Direct Labour (DL) $ 1.40 per gallon Budgeted Production and sales 1,500 gallons Size of Batch 100 gallons Number of setups 3 per batch Size of Purchase Order 40 gallons Time in mixer 0.40 hour per 100 gallons Time in chiller 1.50 hour per 100 gallons Time in package machine 0.50 hour per 100 gallons Chocolate $ 1.90 per gallon $ 1.40 per gallon 80,000 gallons 4,000 gallons 3 per batch 500 gallons 0.20 hour per 100 gallons 1.50 hour per 100 gallons 0.25 hour per 100 gallons

Case Questions

1.      Utilizing the information above, calculate the full product cost (on a per gallon basis) of the Peanut Butter Bacon and Chocolate flavours utilizing:

a.      Samantha's more traditional costing system.

b.      Laura's suggestion to use activity-based costing.

2.      What are the impacts, if there is any at all, of switching CSL's costing method? In particular, are the any significant contrasts between traditional costing and activity-based costing in terms of:

a.      Their impact on costs for independent products.

b.      Their effect on CSL's total firm income? (assuming everything else remains the same, such as production and sales prices)

c.       If there are significant contrasts, why are they present? If there are no significant contrasts, why are they not present?

3.      What would you recommend to be Samantha's next step, based on this analysis? Explain.

Answer 1

Answer with working notes is given below

Traditional Overhead rate Total Overheads Direct labor cost $450,000 $200,000 225.00% % of Direct Labour cost Chocolate Budgeted production Direct Labor cost per gallon Total Direct Labor cost Manufacturing Overhead % DL Cost Overhead applied Total Output Overhead cost per unit Peanut Butter Bacon 1,500 $1.40 $2,100 225% $4,725 1,500 $3.15 80,000 $1.40 $112,000 A 225% $252,000 B 80,000 $3.15 A/B Chocolate Total manufacturing cost per unit- Traditional Costing Peanut Butter Bacon Direct Material $2.20 Direct Labor $1.40 Total Overhead allocated $3.15 Total manufacturing cost per gallon $6.75 $1.90 $1.40 $3.15 $6.45 Calculation of Activity rates Activity Activity rate Total Activities 829 1,766 Purchasing Material handling Mixing Chilling Packaging Quality Control Total budgeted indirect costs Total Overheads $60,000 $71,250 $91,500 $131,250 $82,500 $13,500 $450,000 920 1,856 1,020 206 $72.38 per purchase order $40.35 per set up $99.46 per mixing hour $70.72 per chilling hour $80.88 per packaging hour $65.53 per batch Allocation of Overheads - ABC method Cost activity rate Activities used Allocated Cost Activity Peanut Butter Bacon Chocolate Chocolate 160 60 1,200 Purchasing $72.38 Material handling $40.35 Mixing $99.46 Chilling $70.72 Packaging $80.88 Quality Control $65.53 Total ABC allocated indirect cost Total Volume Overhead cost per unit Peanut Butter Bacon $2,714 $1,816 $597 $1,591 $607 $983 $8,307 1,500 $5.54 200 $11,580 $2,421 $15,913 $84,860 $16,176 $1,311 $132,261A 80,000 B $1.65A/B Working notes for Cost drivers Chocolate Total Peanut Butter Bacon 1,500 Budgeted production and sales Size of purchase orders- gallons Number of purchase orders 80,000 500 160.00 37.50 197.50 4,000 Size of batch gallons Total batches Set ups - 3 per batch (Batches X 3 per batch) Mixing hour per 100 gallons Total hours 166 Chilling hour per 100 gallons Total hours 22.50 1,200 1,223 Packing time per 100 gallons Total hours 0.25 200 7.50 208 Chocolate Total manufacturing cost per unit- ABC method Peanut Butter Bacon Direct Material $2.20 Direct Labor $1.40 Total Overhead allocated $5.54 Total manufacturing cost per gallon $9.14 $1.90 $1.40 $1.65 As per above working $4.95 Comparison of Product Cost Cost per Gallon Peanut Butter Chocolate Bacon $6.75 $6.45 $9.14 $4.95 Under-Costing Over-Costing Traditional Costing ABC Costing Comments a) Peanut Butter Bacon was under-costed as per Traditional costing system Chocolate was over-costed as per Traditional costing system b) The effect on total income will be nil since cost gets allocated between various products and overall overheads will be same in Income Statement Only effect will be on Product level costing and profitability c) There are significant contrast presents mainly due to the cost driver allocation Traditional costing allocates cost based on single driver- Direct Labor cost method in this case Since Direct labor hour cost is same per unit cost is getting allocated equally But in Activity based costing allocation is based on activities consumed.. Hence cost allocation will be higher for higher activities consumed ABC method of Costing is more realistic since it allocates cost based on actual consumption of activities 3) Recommendation: Peanut Butter Bacon is having higher activities consumption for production. Hence the firm should review the activities consumed and try to reduce the same so that cost allocation to it reduces and cost per unit lowers