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.

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Answer 1

Answers:

1. John Orland is already aware that new flavor of juice i.e. C&D is a hit in the market and people have high demand for it and are even ready to pay 5 to 10% more for that product. Also the current system of costing used by the company is not providing appropriate results in the pricing of the products hence, leading to loss in flavors A&B. John should incorporate ABC method of costing to get appropriate results and focus more on producing flavors C&D instead of A&B. By following ABC method the company will be well ahead in the market compared to its competitors.

2.

		Present Situation
	A	B	C	D	Total
Sales	86000	52000	16000	3600	157600
Costs:
Direct Material	28000	20000	5500	400	53900
Direct Labour	9500	5000	1500	500	16500
Overhead Cost	38000	20000	6000	2000	66000
Total Cost	75500	45000	13000	2900	136400
Operating Income	10500	7000	3000	700	21200
Profit (%)	12	13	19	19	13

		After ABC
	A	B	C	D	Total
Sales	86,000	52,000	16,000	3,600	157,600
Costs:
Direct Material	28,000	20,000	5,500	400	53,900
Direct Labour	9,500	5,000	1,500	500	16,500
Overhead Cost: (on the basis of sales %)
Production Run	12,305	7,440	2,289	515	22,550
Set Up	9,577	5,791	1,782	401	17,550
Manage Products	8,813	5,329	1,640	369	16,150
Run Machine	5,320	3,217	990	223	9,750
Total Cost	73,515	46,777	13,701	2,408	136,400
Operating Income	12,485	5,223	2,299	1,192	21,200
Profit (%)	15	10	14	33	13
			After ABC
Working Note			Overhead Cost Allocation
	Production Run	Set Up	Manage Products	Run Machine	Total
Support Staff Wages	12,000	12,000	6,000	-	30,000
Benefits and Insurance	4,800	4,800	2,400	-	12,000
Information Systems	3,000	-	7,000	-	10,000
Equipment	-	-	-	7,000	7,000
Maintenance	2,000	-	-	2,000	4,000
Utilities	750	750	750	750	3,000
Total	22,550	17,550	16,150	9,750	66,000

After using ABC cost allocation there is an increase in the profit % of flavor D from 19% to 33%. There is a decrease in overhead cost in flavors A and D.