Implementation of Activity-based costing (ABC) The case of a Juice Company

John Orland, controller of the Juice Company, has been concerned over the erosion of the recent financial results especially for the standard flavors (A and B) which used to earn a hefty 20 per cent of profit margin.

Recently, Dan Brun, the sales manager has expanded the lines of products to encompass new flavors (B & C) which were in high demand by customers who were willing to pay 5 to 10 % premium.

Richard Dunn, the manufacturing manager, was also excited to introduce the new flavors since they were expected to generate higher margins while using the same technology as standard flavors. However, he noticed that the introduction of new flavors added some technical complexities to the production process. For instance, unlike Flavors A & B, which were produced in huge volume and in long production runs, difficulties started to arise with the new flavors which were produced in smaller batches but required more changeovers and more production runs (see Exhibit 3).

The Juice Company produced the different flavors in the same factory. Each flavor had a bill of materials that determines the quantity and cost of direct materials used for the production of each flavor. Additionally, a cost sheet was used to track the direct labor expenses incurred at each operating step for each of the four flavors. All overhead costs were grouped at the plant level and allocated to each flavor on the basis of direct labor cost. The rate was set at 400 % of direct labor costs (see Exhibit 2).

John was intrigued by the behavior of their main competitors who were more interested in competing in, what appears according to the company's current costing system, to be low profit margin flavors (A and B) than in high profit margins (Flavors C &D). Such behavior has led the controller to question the accuracy of that costing system and to conclude that the current method of allocation of indirect costs is distorting their product costs thereby causing inappropriate pricing.

To remedy the distortions caused by the traditional method of costing based on one single cost pool of indirect costs, John decided to implement Activity-based costing (ABC) method which focuses on the activities, how they are performed, and the resources they consumed and to assign activities costs to products based on how much demand each of these products puts on these activities. After careful analysis of the company's operations, the controller identified four main activities: process production run, set up equipment, manage products, and run machines. The demand on these activities by different flavors is illustrated in Exhibit 3.

He began by identifying the resources that were being consumed by activities. These resources were grouped in six categories as shown in Exhibit 1.

1

After interviewing the department heads in charge of support staff wages and benefits and insurance, he found out that their services are used by three activities: process production run (40%), set up (40%), and the remaining 20 % consumed to manage products.

Next, the controller tackled the information system item and determines, after interview with the head of the information system department, that process production runs accounts for 30 % of their services while 70 % are used to manage products.

The results of his investigations about the usage of the equipment revealed that it was entirely used to run machines. Maintenance services were shared equally between the production run activity and run machine activity. Finally, utility was shared equally by the four activities.

Questions

1. Describe the problem the company is facing

2. Calculate the costs for the four favors using ABC

3. Explain why, in this case, the ABC costs are different from those calculated under the traditional method based one single cost pool of indirect costs and provide examples from the case that support your analysis.

Exhibit 1

Resources Used

Costs of Resources

Support staff wages

$ 30,000

Benefits and insurances

12,000

Information Systems

10,000

Equipment

7,000

Maintenance

4,000

Utilities

3,000

Total

$ 66,000

Exhibit 2: Traditional Income Statement

Flavor A

Flavor B

Flavor C

Flavor D

Total

Sales

$ 86,000.00

$ 52,000

$ 16,000

$ 3,600

$ 157,600.00

Diredct Material costs

28000

20000

5500

400

53900

Direct labor costs

9500

5000

1500

500

16500

Overhead costs at 400% of Direct labor costs

38000

20000

6000

2000

66000

Operating Income

$ 10,500.00

$ 7,000.00

$ 3,000.00

$ 700.00

$ 21,200.00

Profit margin

12%

13%

19%

19%

13%

2

Exibit 3: direct costs and and activity cost drivers

Flavor A

Flavor B

Flavor C

Flavor D

Total

Sales in units

60,000

50,000

10,000

2,000

122,000

Sales in Dlollars

$ 86,000.00

$ 52,000

$ 16,000

$ 3,600

$ 157,600.00

Unit selling price

$ 1.43

$ 1.04

$ 1.60

$ 1.80

Machine hours per unit

0.1

0.1

0.1

0.1

12200

Production runs

50

50

38

12

150

Set up times ( hours)

150

120

200

100

570

Manage products

1

1

1

1

4

Implementation of Activity-based costing (ABC) The case of a Juice Company John Orland, controller of the Juice Company, has been concerned over the erosion of the recent financial results especially for the standard flavors (A and B) which used to earn a hefty 20 per cent of profit margin. Recently, Dan Brun, the sales manager has expanded the lines of products to encompass new flavors (B & C) which were in high demand by customers who were willing to pay 5 to 10 % premium. Richard Dunn, the manufacturing manager, was also excited to introduce the new flavors since they were expected to generate higher margins while using the same technology as standard flavors. However, he noticed that the introduction of new flavors added some technical complexities to the production process. For instance, unlike Flavors A & B, which were produced in huge volume and in long production runs, difficulties started to arise with the new flavors which were produced in smaller batches but required more changeovers and more production runs (see Exhibit 3). The Juice Company produced the different flavors in the same factory. Each flavor had a bill of materials that determines the quantity and cost of direct materials used for the production of each flavor. Additionally, a cost sheet was used to track the direct labor expenses incurred at each operating step for each of the four flavors. All overhead costs were grouped at the plant level and allocated to each flavor on the basis of direct labor cost. The rate was set at 400 % of direct labor costs (see Exhibit 2). John was intrigued by the behavior of their main competitors who were more interested in competing in, what appears according to the company's current costing system, to be low profit margin flavors (A and B) than in high profit margins (Flavors C &D). Such behavior has led the controller to question the accuracy of that costing system and to conclude that the current method of allocation of indirect costs is distorting their product costs thereby causing inappropriate pricing. To remedy the distortions caused by the traditional method of costing based on one single cost pool of indirect costs, John decided to implement Activity-based costing (ABC) method which focuses on the activities, how they are performed, and the resources they consumed and to assign activities costs to products based on how much demand each of these products puts on these activities. After careful analysis of the company's operations, the controller identified four main activities: process production run, set up equipment, manage products, and run machines. The demand on these activities by different flavors is illustrated in Exhibit 3. He began by identifying the resources that were being consumed by activities. These resources were grouped in six categories as shown in Exhibit 1. 1 After interviewing the department heads in charge of support staff wages and benefits and insurance, he found out that their services are used by three activities: process production run (40%), set up (40%), and the remaining 20 % consumed to manage products. Next, the controller tackled the information system item and determines, after interview with the head of the information system department, that process production runs accounts for 30 % of their services while 70 % are used to manage products. The results of his investigations about the usage of the equipment revealed that it was entirely used to run machines. Maintenance services were shared equally between the production run activity and run machine activity. Finally, utility was shared equally by the four activities. Questions 1. Describe the problem the company is facing 2. Calculate the costs for the four favors using ABC 3. Explain why, in this case, the ABC costs are different from those calculated under the traditional method based one single cost pool of indirect costs and provide examples from the case that support your analysis. Exhibit 1 Resources Used Support staff wages Benefits and insurances Information Systems Equipment Maintenance Utilities Total Costs of Resources $ $ 30,000 12,000 10,000 7,000 4,000 3,000 66,000 Exhibit 2: Traditional Income Statement Flavor A Flavor B Flavor C Flavor D Total Sales $ 86,000.00 $ 52,000 $ 16,000 $ 3,600 $ 157,600.00 Diredct Material costs 28000 20000 5500 400 53900 Direct labor costs 9500 5000 1500 500 16500 Overhead costs at 400% of Direct labor costs 38000 20000 6000 2000 66000 Operating Income $ 10,500.00 $ 7,000.00 $ 3,000.00 $ 700.00 $ 21,200.00 Profit margin 12% 13% 19% 19% 13% 2 Exibit 3: direct costs and and activity cost drivers Flavor A Flavor B Flavor C Flavor D Total Sales in units 60,000 50,000 10,000 2,000 122,000 Sales in Dlollars $ 86,000.00 $ 52,000 $ 16,000 $ 3,600 $ 157,600.00 Unit selling price $ 1.43 $ 1.04 $ 1.60 $ 1.80 Machine hours per unit 0.1 0.1 0.1 0.1 12200 Production runs 50 50 38 12 150 Set up times ( hours) 150 120 200 100 570 Manage products 1 1 1 1 4 3