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 (D & 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 routine 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 arbitrarily 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 low margin flavors (A and B) than in high profit margins (Flavors C &D). Such behavior has led the controller to question the accuracy of the costing system used by the company and to conclude that the current method of allocation of indirect costs is distorting their products 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 manufacturing operations of the company and input from engineers as well as manufacturing and operating managers, 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.

In order to determine the costs incurred to perform these various activities, he began by identifying the resources that were being consumed by these activities. These resources were then grouped in six categories as shown in Exhibit 1. To gather the required new cost information, he proceeded to interview 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 (35%), set up (35%), and the remaining 30 % 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 25 % of their services while 75 % 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

Describe the problem the company is facing

Estimate the costs for the four pens products using ABC

Explain why the ABC costs are different from those provided by the traditional method based one single cost pool of indirect costs.

What are the managerial implications for the revised estimates? (i.e.,What would you do if you were the manager of the company and why?)

Exhibit 1
	Resources Used	Costs of Resources
	Support staff wages	$ 40,000.00
	Benefits and insurances	15000
	Information Systems	12000
	Equipment	8000
	Maintenance	6000
	Utilities	2000
	Total	$ 83,000.00

Exhibit 2: Traditional Income Statement
	Flavor A	Flavor B	Flavor C	Flavor D	Total
Number of units produced	80000	60000	12000	3000	155000
Sales	$ 82,000.00	$ 55,000.00	$ 16,000.00	$ 4,000.00	$ 157,000.00
Material Costs	$ 18,000.00	$ 9,000.00	$ 5,200.00	$ 1,000.00	$ 33,200.00
Direct Labor Costs	$ 10,900.00	$ 7,800.00	$ 1,600.00	$ 450.00	$ 20,750.00
Indirect Costs (400% of direct labor costs	$ 43,600.00	$ 31,200.00	$ 6,400.00	$ 1,800.00	$ 83,000.00
Total operating income	$ 9,500.00	$ 7,000.00	$ 2,800.00	$ 750.00
Profit margin percentage	12%	13%	18%	19%

Exhibit 3: Activity usage
	Flavor A	Flavor B	Flavor C	Flavor D	Total
Production sales in units	80000	60000	12000	3000	155000
Sales in Dollars	$ 82,000.00	$ 55,000.00	$ 16,000.00	$ 4,000.00	$ 157,000.00
Machine hours per unit	0.1	0.1	0.1	0.1	15500
Production runs	60	60	30	10	160
Total setup time (hours)	160	130	180	90	560
Manage Products	1	1	1	1	4