Question

Idaho Potatoes operates at capacity and processes potatoes into potato cuts at its highly automated Pocatello plant. It sells potatoes to the retail consumer market and to the institutional market, which includes hospitals, cafeterias, and university dormitories.

IP’s simple costing system, which does not distinguish between potato cuts processed for retail and institutional markets, has a single direct-cost category (direct materials, i.e. raw potatoes) and a single indirect-cost pool (production support). Support costs, which include packaging materials, are allocated on the basis of pounds of potato cuts processed. The company uses 1,200,000 pounds of raw potatoes to process 1,000,000 pounds of potato cuts. At the end of 201X, IP unsuccessfully bid for a large institutional contract. Its bid was reported to be 30% above the winning bid. This feedback came as a shock because IP included only a minimum profit margin on its bid and the Pocatello plant was acknowledged as the most efficient in the industry.

As a result of its review process of the lost contract bid, IP decided to explore ways to refine its costing system. The company determined that 90% of the direct materials (raw potatoes) related to the retail market and 10% to the institutional market. In addition, the company identified that packaging materials could be directly traced to individual jobs ($180,000 for retail and $8,000 for institutional). Also, the company used ABC to identify three main activity areas that generated support costs: cleaning, cutting and packaging.

• Cleaning Activity Area – The cost-allocation base is pounds of raw potatoes cleaned.
• Cutting Activity Area – The production line produces (a) 250 pounds of retail potato cuts per cutting-hour. (b) 400 pounds of institutional potato cuts per cutting-hour. The cost-allocation base is cutting-hours on the production line.
• Packaging Activity Area – The packaging line packages (a) 25 pounds of retail potato cuts per packaging-hour   (b) 100 pounds of institutional potato cuts per packaging-hour. The cost-allocation base is packaging-hours on the production line.

The following table summarizes the actual cost for 201X before and after the preceding cost analysis:

	Before the cost analysis	After the cost analysis
		Production Support	Retail	Institutional	Total
Direct materials used
Potatoes	$150,000		$135,000	$15,000	$150,000
Packaging			180,000	8,000	188,000
Production Support	983,000
Cleaning		$120,000			120,000
Cutting		231,000			231,000
Packaging		444,000			444,000
Total	$1,133,000	$795,000	$315,000	$23,000	$1,133,000

1. Using the simple costing system, what is the cost per pound of potato cuts produced by IP?
2. Calculate the cost rate per unit of the cost driver in the (a) cleaning, (b) cutting, and (c) packaging activity areas.
3. Suppose IP uses information from its activity cost rates to calculate costs incurred on retail potato cuts and institutional potato cuts. Using the ABC system, what is the cost per pound of (a) retail potato cuts and (b) institutional potato cuts?
4. Comment on the cost differences between the two costing systems in requirement 1 and 3. How might IP use the information in requirement 3 to make better decisions?

Answer 1

1.

ABC, activity area cost-driver rates, product cross-subsidization.
1. Direct costs
Direct materials	$	150,000
Indirect costs
Product support		983,000
Total costs	$	1,133,000

	Cost per pound of potato cuts	=	$1,133,000	= $1.133
			1,000,000
2. Cost	Costs in	Number of	Costs per
	Pool	Pool	Driver Units	Driver Unit
	Cleaning	$120,000	1,200,000 raw pounds	$	0.10
	Cutting	$231,000	3,850 hours*	$	60.00
	Packaging	$444,000	37,000 hours**	$	12.00

	*(900,000 ÷ 250)+ (100,000÷ 400)= 3,600 +		250 =	3,850
	**(900,000 ÷ 25) + (100,000÷ 100)= 36,000 + 1,000 = 37,000
3.	Retail Potato Cuts	Institutional Potato Cuts
	Direct costs
	Direct materials	$135,000					$15,000
	Packaging	180,000		$315,000	8,000	$23,000
	Indirect costs
	Cleaning
	$0.10 × 90%× 1,200,000	108,000
	$0.10 × 10%× 1,200,000							12,000
	Cutting
	$60 × 3,600 hours	216,000
	$60 × 250 hours							15,000
	Packaging
	$12 × 36,000; $12 × 1,000	432,000		756,000	12,000	39,000
	Total costs			$	1,071,000				$62,000
	Pounds produced				900,000			100,000
	Costs per pound			$	1.19			$ 0.62

Note: The total costs of $1,133,000 ($1,071,000 + $62,000) are the same as those in Requirement 1.

4. There is much evidence of product-cost cross-subsidization.

	Cost per Pound	Retail	Institutional
	Simple costing system $1.133		$1.133
ABC system	$1.190	$0.620

Assuming the ABC numbers are more accurate, potato cuts sold to the retail market are undercosted while potato cuts sold to the institutional market are overcosted.

The simple costing system assumes each product uses all the activity areas in a homogeneous way. This is not the case. Institutional sales use sizably less resources in the cutting area and the packaging area. The percentages of total costs for each cost category are as follows:

Direct costs	Retail	Institutional	Total
Direct materials	90.0%	10.0%	100.0%
Packaging	95.7	4.3	100.0
Indirect costs
Cleaning	90.0	10.0	100.0
Cutting	93.5	6.5	100.0
Packaging	97.3	2.7	100.0
Units produced	90.0%	10.0%	100.0%

Idaho can use the revised cost information for a variety of purposes:

a.       Pricing/product emphasis decisions. The sizable drop in the reported cost of potatoes sold in the institutional market makes it possible that Idaho was overpricing potato products in this market. It lost the bid for a large institutional contract with a bid 30% above the winning bid. With its revised product cost dropping from $1.133 to $0.620, Idaho could have bid much lower and still made a profit. An increased emphasis on the institutional market appears warranted.

b.  Product design decisions. ABC provides a road map as to how to reduce the costs of individual products. The relative components of costs are:

Direct costs	Retail	Institutional
Direct materials	12.6%	24.20%
Packaging	16.8		12.90
Indirect costs
Cleaning	10.1		19.35
Cutting	20.2		24.20
Packaging	40.3		19.35
Total costs	100.0	%		100.00	%

Packaging-related costs constitute 57.1% (16.8% + 40.3%) of total costs of the retail product line. Design efforts that reduce packaging costs can have a big impact on reducing total unit costs for retail.

c.  Process improvements. Each activity area is now highlighted as a separate cost. The three indirect cost areas comprise over 60% of total costs for each product, indicating the upside from improvements in the efficiency of processes in these activity areas.