DECEMBER 2021

Our customers just love our specialty tea. However, this smashing success is not evident in our financials. I am utterly puzzled. Maybe we should emphasize regular and premium tea and consider eliminating specialty tea.

Susan Zha, CEO of Bethesda Tea

Bethesda Tea, Inc. (BT) is a processor and distributor of a variety of different blends of tea. The company buys unprocessed tea leaves from around the world; it then dries and packages processed tea for resale. Currently, BT offers its products to tea houses in 1-pound bags. The blends are classified as either regular or premium. The regular blends are popular and sell in large volumes while the premium blends sell in low volumes. BT sells specialty blend tea exclusively to high-end restaurants in 20-pound bags. Although the major cost for BT is the cost of the tea leaves, BT incurs manufacturing overhead costs associated predominantly with the automated drying and packing process.

BT prices its tea based on budgeted full cost (i.e., including allocated overhead). The company aims for a gross margin of 20% from the specialty blend and 25% from the other blends. If prices for specific tea are significantly higher or lower than the market, the prices are adjusted accordingly. Although the company competes primarily on the quality of its tea, its customers are price conscious, and the company must respond accordingly.

Existing Cost System at BT

The existing cost system at BT traces the direct material costs and the direct labor costs to the associated products. Additionally, the system allocates overhead based on direct run labor hours. The operating income statement for BT in 2020 is provided in Exhibit 1. Exhibit 2 provides cost and profit margin information for the three tea products in 2020.

A New Cost Study

Eddie Caffeine, a board member of BT, is developing recommendations about BTs product offerings. He wonders whether BT should change its resource allocation and/or alter its product base to increase profitability. In order to more precisely estimate each products performance, Mr. Caffeine hired an outside consultant to conduct a new cost study which reveals the following information:

1. Set up labor is typically used each time a production run is initiated. The cost seems to be related to the number of labor hours used during the set-up process.

2. Quality control processes are performed after each production run. During this process, a sample of processed tea is analyzed for texture, color, and potential brewing quality.

3. Each time an order is received, tea leaves and other materials must be picked and organized for the customer. These items are then packed and shipped. Actions related to packing and shipping are performed one time for each order. Approximately the same amount of effort is exerted regardless of the order size.

4. Engineering costs are related to engineering staffs workload.

5. The wear on the machine, as estimated by machine overhead, is related to the number of hours

that the machine is in use.

Exhibit 3 contains some of the operating data the consultant compiled for 2020.

Recent Development

While Specialty blend has generated positive customer feedback, its profitability lags behind the regular and premium teas. This is particularly puzzling to Susan Zha, CEO of BT, who believes that the company should have a comparative advantage over its competitors due to its state-of-the-art production facilities. However, maybe the company would be better off reallocating the resources to the regular and premium brands and expanding these products markets.

Recently, an upstart tea house chain, Potomac Tea, would like to use BTs packing services for its operation. Zha is very interested in expanding the companys customer base, but is not sure about the pricing. After conducting some preliminary research, Zha determines that 45% of the budgeted packing cost is fixed; Additionally, the capacity utilization of BTs packing facility is currently at 50%. Potomac Tea is expecting to ask BT to handle 5 shipments.

Finally, BT is in the process of budgeting for 2021. It expects that the 2021 sales volume of Specialty and Regular tea will increase by 20% each and sales of Premium tea will drop by 10%. The sales price for all three varieties is expected to stay constant. Labor wage rate is expected to rise by 20%.

Exhibit 1: 2020 Budgeted Operating Income Statement

Revenues ----------------------------------------------------$4,990.000.00

Costs

Direct Labor ---------------------------------------------------$255,200.00

Direct Materials---------------------------------------------$1,900.000.00

Overhead

Set-up------------------------------------------------------- --$3,000.00

Quality Control --------------------------------------------$70,000.00

Receiving and Packing ----------------------------------$575,000.00

Engineering------------------------------------------------$352,000.00

Machine Costs--------------------------------------------$700,000.00

Total Overhead ---------------------------------------------$1,700.000.00

Operating Profit-------------------------------------------$1,164,800.00

Exhibit 2: Cost and Profit Margin under Existing Cost System

	Specialty	Regular	Premium
Price per pound	$7.50	$7.80	$11.5
Cost per pound	$6.27	$5.85	$8.14
Profit per pound	$1.23	$1.95	$2.36
Profit Margin %	16.4%	25.0%	29.2%

Exhibit 3: Operating Data for 2020

	Specialty	Regular	Premium	Total
Budgeted Number of Pounds of Processed Tea Sold	200,000	300,000	100,000	600,000
Actual Number of Pounds of Processed Tea Sold	200,000	400,000	100,000	700,000
DM Cost per pound of Tea Sold	$2	$3	$6
Number of Orders	5	18	100	123
Number of Production Runs	1	3	10	14
Set-up Labor Hours	10	90	1,100	1200
Direct Run Labor Hours	5000	5,010	1,250	11,260
Machine Hours	2,500	5,010	2,500	10,010
Engineering Staff % Workload	25%	35%	40%	100%
Selling Price per pound	$7.50	$7.80	$11.5
Labor Rate	$20 per hour

Q.2 Diagram (or explain) the existing cost system used at BT to assign costs to its products in 2020. Clearly identify the allocation bases as well as the rates used to assign these costs.?

Q.3 Is the existing cost system suitable for BT? (No calculations are needed for these questions.) ?

Q.4 If BT uses DM dollars as the sole cost driver (instead of direct labor), how would this aect the overhead costs allocated to each product? Would this change solve any concerns that you might have with the system? (No calculations are need for this question.) ?

Q.5 Diagram the cost system suggested by the consultant (new cost study) for 2020? Clearly identify the allocation bases as well as the rates used to assign costs. Is this an ABC system? Why?

Q.6 Calculate the cost and prot margin percentage (as a percentage of selling price) for specialty, regular and premium tea under the new cost study in 2020, respectively. (Note: you may complete this for either one pound of each type of tea or for total sales volume.)

Q.7 Would you recommend that BT keep the separate set-up overhead pool under the new cost study? Explain your answer.

Q.8 Based on the new cost study, list two things that BT can do to improve its production efficiency?

Q.9Based on the new cost study, would you recommend dropping any of the products? If so, which one and why?

Q.10 Nick Snyder, BT's purchasing manager for regular tea, is responsible for negotiating prices of unprocessed tea leaves with suppliers. The amount of tea leaves purchased is set by the production manager. In 2020, the budget forecasted that BT would purchase 600,000 pounds of unprocessed regular tea leaves at a cost of $900,000. In 2020, BT actually purchased 900,000 pounds of unprocessed regular tea leaves at a total cost of $1,170,000. Explain the reasons, quantitatively and qualitatively, for the difference between the budgeted and actual cost of regular unprocessed tea leaves. How would you evaluate Snyder's performance in 2020?

Q.11 Calculate the budgeted revenue and direct labor cost for the three products in 2021, respectively.

Q.12 BT is using the number of packs tea packs finished per hour to evaluate its packing employees. List one pro and one con of this performance measure. (No details calculations are necessary for this question.)

Q.14 BT is considering reorganizing its packing facility into a new division and allowing it to charge a transfer price on every shipment it handles for internal divisions. What transfer price would you recommend?