Hershee Chocolate Company Lori Hershee, controller of her family's business, Hershee Chocolate Company (HCC), was concerned about the nancial results for the most recent fiscal year. She had just started working in the role, after her father retired, and was eager to see the company thrive. In 2005, Lori's father and her uncle began HCC, a family-owned confectionary company. The company's mission is to produce high quality chocolate made from ethically sourced ingredients that is affordable. For years, HCC focused on producing only two products: milk chocolate bars and dark chocolate bars. Afew years ago, the company started to expand its chocolate product offerings by adding white chocolate bars (made from cocoa butter and no cocoa solids) to its product line. The white chocolate bars could be sold at higher prices compared to the milk chocolate and dark chocolate bars. Last year, the company had also started producing toffee bars (a milk chocolate bar with a crisp toffee center), which used the same chocolate that was used for the milk chocolate bars. The toffee bars could be sold at even higher prices than the white chocolate bars. HCC primarily sold and distributed its products to retail stores. Lori had reviewed the most recent financial results and was disappointed. While the white chocolate and toffee bars seemed to be more profitable than the two original chocolate bars, the company's overall protability was down. She wondered if the decline in prots was due to the increasingly tough competition in the confectionary industry, particularly from its two largest competitors, Neslee and Cadberry. She also pondered whether HCC should reduce production of their two original chocolate bars to introduce other new products, since the white chocolate and toffee bars appeared to be generating higher gross prot margin percentages compared to the milk chocolate and dark chocolate bars (see Exhibit 1). Production Jose Gonzalez, the production manager, had approached Lori concerned with the current state of the production facilities. Production was much simpler when they only had the milk chocolate and dark chocolate bars to produce. The production lines could run in long production runs, and everything ran smoothly. Problems began when the white chocolate bars were introduced, and the production employees had to start completing more time-consuming machine setups. Production of the white chocolate bars required the production employees to have to stop production, empty the vats of chocolate from the previous production runs, thoroughly clean the vats, and then start the production of the white chocolate bars. The recent addition of the toffee bars to the product line added further demands on production, with additional setups and longer setup times required because of the toffee centers that also had to be added. HCC produced all of its chocolate bars in a single production facility. The major production task was preparing and mixing all of the ingredients that went into each of the different chocolate mixtures for each of the products. The chocolate mixtures, which were held in large vats, were dispensed into molds in a semi-automated process. Packaging of the individual chocolate bars was also completed in a semi-automated process. The final packing of the products was performed manually by production employees. Each product had a bill of materials that identied the quantity and cost of direct materials required. A routing sheet identied the sequence of processes required to complete each production run. This information was used to calculate the direct labour expenses for each of the four products. All of the production facility's indirect expenses were aggregated at the production facility level and allocated to each product based on their direct lab0ur expenses. Currently, the overhead rate was 300% of direct labour expenses. Prior to the introduction of the white chocolate and toffee bars, the overhead rate was only 200%. Activity-Based Costing Thinking back to what she had learned while completing her Bachelor of Business Administration degree at Wilfrid Laurier University, Lori recalled learning about activity-based costing (ABC) in her BU247 class. After reviewing her old caurse notes, she thought that ABC might be a good costing system to use at HCC. To get started, Lori first identied six categories of overhead expenses that had been allocated to the production facility for the most recent fiscal year: Overhead Category Overhead Amount Indirect Labour $20,000 Fringe Benets 17,600 Computer System 8,000 Machines 15,000 Machine Maintenance 6,000 Utilities 5 400 Total $72,000 Lori determined that the fringe benets were 40% of the salaries and wages for both direct and indirect labour and should be a percentage markup applied on top of the direct and indirect labour expenses. After meeting with Jose, Lori found that the indirect labour employees were involved in three production support activities. About half of indirect labour was responsible for scheduling and supporting the production runs. This activity consisted of scheduling the production runs, preparing and releasing ingredients to be used for the production runs, and handling of some scrap loss at the beginning of each production run. Another 40% of indirect labour was required to complete the machine setups between productions runs. The times required to setup the machines to produce the milk chocolate and the dark chocolate bars were relatively short since the previous chocolate mixtures for the other chocolate bars did not have to be completely eliminated from the vats between the production runs. The other two chocolate bars, particularly the white chocolate bars, required more extensive setups. The remaining 10% of indirect labour was involved in maintaining inventory records for the four products, including monitoring and maintaining a minimum supply of raw materials and nished goods inventory for each product. Next, Lori turned her attention to the $8,000 of overhead expenses to operate the computer system used for the production facility. After talking to the manager of the Information Technology department, she determined that about 80% of the computer's time was used for scheduling the production runs, and the remaining 20% was used for maintaining inventory records on the four products. The remaining categories of overhead expenses (machine depreciation, machine maintenance, and the utilities used to operate the machines) were incurred to supply machine capacity to produce the four products. The production machines had a total practical capacity of 5,000 machine hours. Lori collected information on potential activity cost drivers for HCC's production activities and the distribution of the cost drivers for each of the four products (see Exhibit 2). Lori believed that she now had the information she needed to implement an ABC system for HCC. Exhibit 1: Hershee Chocolate Company: Total and Product Profitability Milk Dark White Toffee Total Chocolate Chocolate Chocolate Sales 35 87,500 $ 70,000 $ 18,000 $ 2,500 $ 178,000 Direct materials 25,000 20,800 4,320 550 50,870 Direct labour 12,000 9,800 2,180 240 24,000 Overhead @ 300% of direct labour 38,000 28,800 8,480 720 72 000 Gross prot $ 14,500 $ 10,800 $ 5,040 $ 990 $ 31,330 Exhibit 2: Direct Costs and Activity Cost Drivers Milk Dark White Toffee Total Chocolate Chocolate Chocolate Production sales volume 50,000 40,000 9,000 1,000 100,000 units Unit selling price $1.75 $1.75 $2.00 $2.50 Direct materials cost per $0.50 $0.52 $0.48 $0.55 unit Direct labour hours 0.02 per unit 0.02 per unit 0.02 per unit 0.02 per unit 2,000 hours Machine hours 0.05 per unit 0.05 per unit 0.05 per unit 0.05 per unit 5,000 hours Production runs a 50 50 40 10 150 runs Machine setup time per 1 1 6.5 4 production run (hours) Time to maintain product 30 30 20 20 100 hours inventory records (hours) 1. Discuss the current costing practices used by HCC to allocate overhead costs to each of the four products, including whether it is an appropriate costing method now that HCC has increased the number of different chocolate bars. [0.5 marks] Revise HCC's Total and Product Profitability statement presented in Exhibit 1 using the new ABC system. In your revised protability statement, make sure to include separate line items for each of the overhead activity costs allocated to each product. [2 marks]