Question

Implementation of Activity-based costing (ABC) The case of a Juice Company John Orland, controller 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 hefty 20 per cent of profit margin. Recently, Dan Brun, the sales manager has expanded the lines of products to encompass new flavors (C & C) which were in high demand by customers who were willing to pay 5 to 10% premium. 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 determines the quantity and cost of direct materials used for the production of 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 allocated to each flavor on the basis of direct labor cost. The rate was set at 400% of direct labor costs (see Exhibit 2). John 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 controller to question the accuracy of that costing system and to conclude that the current method of allocation of indirect costs is distorting their product costs thereby causing inappropriate pricing. To remedy the distortions caused by the traditional method of costing based on one single cost pool of indirect costs, John 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, the controller 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.

Answer 1

Answer to 1, 2 and 3

The company is using incorrect costing methodology of traditional method of 400% of direct labour costs. Activity based costing should be used in order to allocate costs as per the actual usage of activities in products.

As per the traditional method, all the products are in profit with B and C with higher margins of 19% and A and B with lower margins of 12% and 133 respectively.

However, as per the ABC methodology, products C and D are in loss of 48% and 177% respectively and products A and B have profit margins of 32% and 15% respectively. Therefore, products C and D should be discontinued.

Detailed workings are as below:

Traditional method

	A	B	C	D	Total
Sales	86000	52000	16000	3600	157600
DM	28000	20000	5500	400	53900
DL	9500	5000	1500	500	16500
O/H	38000	20000	6000	2000	66000
Operating income	10500	7000	3000	700	21200
Profit	12%	13%	19%	19%	13%

ABC Method

	A	B	C	D	Total
Sales	86000	52000	16000	3600	157600
DM	28000	20000	5500	400	53900
DL	9500	5000	1500	500	16500
Overheads	20,968	19,245	16,707	9,080	66000
Operating income	27,532	7,755	(7,707)	(6,380)	21,200
Profit	32%	15%	-48%	-177%	13%

Calculation of overheads

Total activity costs under 4 activities:

Total cost	30,000	12,000	10,000	7,000	4,000	3,000
	Wages and bnenefits	Benefits and ins	IT	Equipment usage	Maintenace	Utility
Process production run	40%	40%	30%		50%	25%
Setup equipment	40%	40%				25%
Manage products	20%	20%	70%			25%
Run machines				100%	50%	25%

	30,000	12,000	10,000	7,000	4,000	3,000
	Wages and bnenefits	Benefits and ins	IT	Equipment usage	Maintenace	Utility	TOTAL
Process production run	12,000	4,800	3,000	-	2,000	750	22,550
Setup equipment	12,000	4,800	-	-	-	750	17,550
Manage products	6,000	2,400	7,000	-	-	750	16,150
Run machines	-	-	-	7,000	2,000	750	9,750

Activity allocation on products

Sale units	60000	50000	10000	2000	122000
Unit selling price	1.43	1.04	1.60	1.80
Machine hours per unit	0.1	0.1	0.1	0.1
Machine hours	6000	5000	1000	200	12200
Production runs	50	50	38	12	150
Set up time (Hours)	150	120	200	100	570
Manage products	1	1	1	1	4

Overheads calculation

	A	B	C	D	Total	Basis
Overheads	20,968	19,245	16,707	9,080	66000
Process production run	7,517	7,517	5,713	1,804	22550	Production runs
Setup equipment	4,618	3,695	6,158	3,079	17550	Set up time (Hours)
Manage products	4,038	4,038	4,038	4,038	16150	Manage products
Run machines	4,795	3,996	799	160	9750	Machine hours