Question

Several years ago, Ingrid Krause wanted some international experience and applied for a transfer to her company's soap division, which is located south of Warsaw, Poland. The soap division manufactures hand soap for use in a large number of settings, from hospitals to luxury hotels. Ingrid was awarded the transfer to the soap division and was assigned to the accounting department. She is responsible for overseeing the cost ing and profitability analysis of the various soaps and soap-making processes. During her tenure in the soap division, there were numerous changes in the number of soaps manufactured and the processes to make the different soaps. Consequently, Ingrid's position required her to consider changes in the accounting system to reflect the changes in the soap division's business. For several decades, the company's soap-making process required a large labour force that manufac- tured and packaged the soap mostly by hand. Local economic changes meant that the labour force that the factory required was not as available as it had been in the past. As a result, the division was experiencing significant employee turnover, which often resulted in increased expenses related to training new hires, slower processing time, and more soap being rejected during inspections because of quality concerns. To address the issues related to the lack of labour availability, the division's management decided three years ago that automation was the way to go. Consequently, over the last three years, the soap-making processes have changed with the implementation of automation. The automation of the soap-making process has allowed for a much larger variety of soap and packag- ing, a reduced direct labour force and direct labour costs, and a higher level of traceability of costs to the various soaps because of technological improvements. Soaps made for industrial applications require dif- ferent ingredients, less time in processing, less time in finishing, and less time in and cheaper packaging than do soaps made for the hotel industry. The costs of materials and packaging are directly traceable to the various types of soaps through new software that uses bar codes and counters to trace direct material costs to the various soaps directly. Ingrid feels that the current costing system should be revisited. The cost driver for allocation of the overhead costs (such as supervisory salaries and plant utilities) has always been direct labour cost. However, given the decline in the use of labour due to automation, Ingrid is questioning its suitability as a basis of allocation. Ingrid would like to explore activity-based costing to allocate overhead costs. Ingrid has gathered cost data for two representative soaps: one sold to hospitals and one sold to hotels. Further, Ingrid has gathered data from the automated system on the amount of time each type of soap spends in the three manufacturing processes: processing, finishing, and packaging. The soap is produced in large batches; consequently, the data are adjusted to reflect the average cost per 100 g of soap. The data by type of soap for one month's production are in Exhibit 1. Required Prepare a report for Ingrid Krause that addresses her interest in exploring an activity-based costing (ABC) system while including the following: (a) Is Ingrid's exploration of changing her cost allocation of overhead from a traditional approach (one cost driver for allocation) to an ABC approach (multiple cost drivers applied to multiple cost pools) (b) Calculate the costs (of direct material, direct labour, and overhead) for each of the two representa- (c) Calculate the costs (of direct material, direct labour, and overhead) for each of the two representa- justifiable? If so, explain to her why it is. tive types of soap using direct labour cost as the base for the allocation of overhead. tive types of soap using an ABC approach for the allocation of manufacturing costs. (d) Do the cost allocation calculations provide support for an ABC approach? Explain. (e) Would you advise Ingrid Krause to continue with her traditional costing approach or change to an ABC approach? Explain. EXHIBIT 1 - COSTS FOR ONE MONTH'S PRODUCTION OF SOAP Costs per 100 g Soap Industrial Soap (HospitalLuxury Soap (Hotel) Cost Components Total $0.80 $0.60 0.15 Direct materials Packaging Direct labour Manufacturing Processing Finishing Packaging $0.40 $0.10 $0.14 $4,000,000 $2,000,000 750,000 $5,000,000 $2,500,000 $1,500,000 $1,000,000 EXHIBIT 2 -TIME REQUIRED FOR ONE MONTH'S PRODUCTION OF SOAP Total Time per 100 g Soap Industrial Soap (Hospital Luxury Soap (Hotel) Time Components Processing Finishing Packaging 750,000 seconds 300,000 seconds 100,000 seconds 0.2 second 0.03 second 0.006 second 0.4 second 0.4 second 0.5 second

Answer 1

ANSWER:

(C)

Process name	Total time in seconds (a)	Total cost (b)	Cost per second (a/b)
processing	750000	2500000	3.33$ per sec
Finishing	300000	1500000	5$ per sec
Packaging	100000	1000000	$10 per sec
Unit cost for both product
		Industrial soap	Luxury soap
Direct material		$0.40	$0.80
packaging		0.10	0.60
Direct labor		0.14	0.15
Manufacturing
Processing		0.67(0.2*3.33)	1.33(0.4*3.33)
Finishing		0.15(0.03*5)	2(0.4*5)
packaging		0.06(0.006*10)	5(0.5*10)
Per unit cost		1.52	9.88

(b)

Particulars	Industrial Soap	Luxury Soap
Direct Material	$0.40	$0.80
Packaging	$0.10	$0.60
Direct Labor	$0.14	$0.15
Manufacturing Overheads	$1.91	$8.89
Total Cost per unit	$2.55	$10.44

• Working Notes

1.Calculation of Cost Driver rates for overhead costs and overhead cost per unit

Particulars	Processing	Finishing	Packaging	Manufacturing	Total
A.Overhead Costs	$25,00,000	$15,00,000	$10,00,000	$50,00,000
B.Total Time	7,50,000	3,00,000	1,00,000	11,50,000
C.Cost driver rate (A/B)	$3.33	$5	$10	$4.35
D. Industrial soap cycle time	0.2	0.03	0.006	0.236
E. Overhead Cost for Industrial Soap (C*D)	$0.67	$0.15	$0.06	$1.0266	$1.91
F. Luxury Soap cycle time	0.4	0.4	0.5	0.13
G.Overhead Cost per Luxury Soap (C*F)	$1.33	$2	$5	$0.56	$8.89

Notes:

1. Activity based costing assigns overhead costs to products in a logical manner compared to the conventional method of absorbing costs to the products using a single cost driver such as direct labor hours and machine hours.
2. Activity based costing seeks to analyse the cause and effect relationship for the cost and the corresponding activity for the creation of such cost, the method identifies activities in an organisation and assigns the cost of each activity to all the products and services according to the actual consumption by each.
3. In the above scenario the soap manufacturing unit has identified different activities i.e processing, finishing, secondary packaging etc. The costs are first pooled to these activities and these costs are then driven to the products by identifying a suitable cost driver, labor hours is chosen as the cost driver in the instant case because it is the number of labor hours that cause or create the overhead cost, similarly number of maintenance hours is the factor that creates the cost of repairs and maintenance of machinery.
4. In the instant case luxury soap appears to be highly priced compared to industrial soap due to the fact that the resources in terms of labor hours per unit for the former is greater than the latter, therefore greater proportion of overhead costs are driven towards luxury soap.