Howard Rockness was worried. His company, Rockness Bottling, showed declining profits over the past several years despite an increase in revenues. With profits declining and revenues increasing, Rockness knew there must be a problem with costs.

Rockness sent an e-mail to his executive team under the subject heading, "How do we get Rockness Bottling back on track?" Meeting in Rockness's spacious office, the team began brainstorming solutions to the declining profits problem. Some members of the team wanted to add products. (These were marketing people.) Some wanted to fire the least efficient workers. (These were finance people.) Some wanted to empower the workers. (These people worked in the human resources department.) And some people wanted to install a new computer system. (It should be obvious who these people were.)

Rockness listened patiently. When all participants had made their cases, Rockness said, "We made money when we were a smaller, simpler company. We have grown, added new product lines, and added new products to old product lines. Now we are going downhill. What's wrong with this picture?"

Rockness continued, "Here, look at this report. This is last month's report on the cola bottling line. What do you see here?" He handed copies of the following report to the people assembled in his office.

Monthly Report on Cola Bottling LineDietRegularCherryGrapeTotalSales$262,500$155,000$51,000$17,225$485,725Less:Materials125,00082,40028,40011,625247,425Direct labor26,50013,5004,00075044,750Fringe benefits on direct labor10,6005,4001,60030017,900Indirect costs (@260% of direct labor)68,90035,10010,4001,950116,350Gross margin$31,500$18,600$6,600$2,600$59,300Return on sales (see note[a])12.0%12.0%12.9%15.1%12.2%Volume105,00062,00020,0006,500193,500Unit price$2.50$2.50$2.55$2.65$2.51Unit cost$2.20$2.20$2.22$2.25$2.20

^aReturn on sales before considering selling, general and administrative expenses.

Rockness asked, "Do you see any problems here? Should we drop any of these products? Should we reprice any of these products?" The room was silent for a moment, and then everybody started talking at once. Nobody could see any problems based on the data in the report, but they all made suggestions to Rockness ranging from "add another cola product" to "cut costs across the board" to "we need a new computer system so that managers can get this information more quickly." A not-so-patient Rockness stopped the discussion abruptly and adjourned the meeting.

He then turned to the quietest person in the room?his son, Rocky?and said, "I am suspicious of these cost data, Rocky. Here we are assigning indirect costs to these products using a 260 percent rate. I really wonder whether that rate is accurate for all products. I want you to dig into the indirect cost data, figure out what drives those costs, and see whether you can give me more accurate cost numbers for these products."

Rocky first learned from production that the process required four activities: (1) setting up production runs, (2) managing production runs, and (3) managing products. The fourth activity did not require labor; it was simply the operation of machinery. Next, he went to the accounting records to get a breakdown of indirect costs. Here is what he found:

Rockness continued, "Here, look at this report. This is last month's report on the cola bottling line. What do you see here?" He handed copies of the following report to the people assembled in his office. Monthly Report on Cola Bottling Line Sales Less: Diet $262,500 Regular $155,000 Cherry $51,000 Grape $17,225 Total $485,725 Materials Direct labor Fringe benefits on direct labor Indirect costs (@260% of direct labor) Gross margin Return on sales (see note [a]) Volume 125,000 82,400 28,400 11,625 247,425 26,500 13,500 4,000 750 44,750 10,600 5,400 1,600 68,900 35,100 10,400 1,950 $ 31,500 $ 18,600 12.0% 105,000 12.0% 62,000 Unit price $ Unit cost $ 2.50 2.20 $ 2.50 $ 2.55 $ 2.65 $ 6,600 12.9% 20,000 $ 2,600 15.1% 6,500 17,900 116,350 $ 59,300 12.2% 193,500 $ 2.51 300 $ 2.20 $ 2.22 $ 2.25 $ 2.20 a Return on sales before considering selling general and administrative expenses