KZ Coffee Bean, Inc. (KZCB) is a processor and distributor of a variety of different blends of coffee. The company buys coffee beans from around the world; it then roasts, blends, and packages the beans for resale. Currently, KZCB offers its products to gourmet shops 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. Additionally, KZCB sells specialty blend coffee exclusively to coffee shops in 20-pound bags. Although the major cost for KZCB is the cost of the beans, there is a substantial amount of manufacturing overhead in the predominantly automated roasting and packing process.

KZCB prices its coffee 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 coffees are significantly higher or lower than the market, the prices are adjusted accordingly. Although the company competes primarily on the quality of its coffee, its customers are price conscious and the company must respond accordingly.

Existing Cost System at KZCB

The existing cost system at KZCB 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 budgeted operating income statement for KZCB in 2019 is provided in Exhibit 1.Exhibit 2 provides cost and profit margin information for the three coffee products in 2019.

A New Cost Study

Frank Smith, a board member of KZCB, is trying to develop recommendations about which products to allocate more resources to and which products should be dropped or altered to improve profitability. In order to more precisely assess each product's performance, Mr. Smith 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 coffee beans is analyzed for texture, color, and potential brewing quality.

3.Each time an order is received, coffee beans and other materials must be picked and organized for the customer.

4.Actions related to packing and shipping are performed each time a shipment is made to a customer. Approximately the same amount of effort is exerted regardless of the size of the shipment.

5.Engineering costs are related to engineering staff's workload.

6.The wear on the machine, as estimated by machine overhead, is related to the number of hours that the machine is in use.

Exhibit 2 contains some of the operating data the consultant compiled for 2019.

Recent Development

While Specialty blend has generated quite positive feedbacks from customers, its profitability significantly lags behind the other two product lines. This is particularly puzzling to James Kyle, CEO of KZCB, 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.

Finally, KZCB is currently considering whether to simultaneously launch two new lines of coffee: F1 and F2. If launched, KZCB will contract an external manufacturing company to make these new products, and the anticipated selling price per pound of coffee is $19 for F1 and $28 for F2. KZCB estimated that its variable cost per pound is $15 for F1 and $20 for F2, respectively. In addition, it is believed that on average a customer will purchase 3 pounds of F1 for every 1 pound of F2. The only other cost is a one-time contract fee paid to the external supplier in the amount of $2,000,000.

Exhibit 1: 2019 Budgeted Operating Income Statement

Revenues

$4,990,000

Costs

Direct Labor

$225,200

Direct Materials

$1,900,000

Overhead

Set-up

$3,000

Quality Control

$70,000

Receiving

$315,000

Packing

Engineering

Machine Costs

$260,000

$352,000

$700,000

Total Overhead

$1,700,000

Operating Profit

$1,164,800

Exhibit 2: Cost and Profit Margin under Existing Cost System

Specialty

Regular

Premium

Price per pound

$7.50

$7.80

$11.50

Cost per pound

$6.27

$5.85

$8.14

Profit per pound

$1.23

$1.95

$3.36

Profit Margin %

16.4%

25.0%

29.2%

1.(5 Points) Diagram the existing cost system used at KZCB to assign costs to its products in 2019. Clearly identify the allocation bases as well as the rates used to assign these costs.

2.(10 points) No detailed calculations are necessary for this question

a. (5 points) Is the existing cost system suitable for KZCB?

b. (5 points) If KZCB instead uses DM dollars as the sole cost driver, how would this affect allocated overhead costs?

3.(10 points) Diagram the cost system suggested by the new cost study for 2019. Clearly identify the allocation bases as well as the rates used to assign costs.

4.(15 points) Calculate the budgeted cost and profit margin percentage (as a percentage of selling price) for one pound of specialty, regular and premium coffee under the new cost study in 2019, respectively.

5.

5(15 points) No detailed calculations are necessary for this question

a. (5 points) Do you agree with having a separate set-up overhead pool as described in the new cost study?Explain your answer.

b. (5 points) KZCB is considering using the insights suggested by the new cost study to set price for its premium coffee customers. What pricing scheme would you recommend in order to incentivize its premium coffee customers to be more efficient?

c. (5 points) Based on the new cost study, would you recommend drop any of the products?If so, which one and why?What additional information do you need?

6(10 points) Betty Barnes, KZCB's purchasing manager for Regular coffee, is responsible for negotiating prices of coffee beans with overseas suppliers.The quantity of coffee beans purchased is set to actual usage determined by Mark Prince, KZCB's production manager for regular coffee.The 2019 budget forecasts KZCB purchases 300,000 pounds of regular coffee beans at a total cost of $900,000.In 2019, KZCB actually purchased 450,000 pounds of regular coffee beans at a total cost of $1,125,000.Explain the reasons for the difference between the budgeted and actual cost of regular coffee beans. How would you evaluate Barnes' and Prince's performance for 2019?

7(10 points) KZCB believes that the demand for F1 coffee will be uniformly distributed between 100,000 pounds and 600,000 pounds. What is the probability that the KZCB will break even if it launches both F1 and F2?

8(10 points) Further analyses revealed that the budgeted fixed machine cost is 300,000 for 2019. In January 2020, when the actual 2019 results came in, Mr. Smith noticed that the actual fixed machine cost is $400,000 which is much higher than the budgeted number.He wanted to apply the concept of demonstrated capacity to further analyze the fixed machine cost variance.After extensive discussions with KZCB employees, Mr. Smith estimated the annual machine demonstrated capacity (in terms of the number of machine hours) is 15,000 hours.The actual number of hours in 2019 is 18,000.To maintain tractability, Mr. Smith decided to run the analysis independent of the formal budgeting process (i.e., demonstrated capacity doesn't affect your answers to any other question of the exam).Conduct a fixed cost variance using the data provided above and explain each of calculated variance.

9(15 Points) KZCB's coffee production division is considering acquiring a new machine.It has obtained the following data that is relevant to its decision to acquire the new machine.(Ignore any tax considerations)

Cost of capital

10%

Initial investment

$6,000*

Annual depreciation

Accelerated

Year

Cash Savings**

Depreciation

1

$3,500

3,000

2

1,800

2,300

3

1,500

600

4

1,200

100

* Initial investment is assumed to occur at the beginning of Year 1.

** Cash savings are assumed to occur at the end of each of the 4 years of operation.

a.(5 Points) Should KZCB purchase the new machine?

b.(5 Points) If the manager of KZCB's production division is evaluated on ROI (using the beginning year asset balance) and the current divisional ROI at OS is 12%, is he likely to approve the purchase? Explain.

c.(5 Points) KZCB is considering replacing ROI with Economic Value Added. EVA would be computed as accounting income less the cost of capital multiplied by the investment base (since the benefits are already measured in cash). In other words, EVA, in this case, is simply residual income (as there is no intangible). The investment base is the book value of the assets at the beginning of the year. If EVA is used as the performance measure for the production division manager, is the manager likely to approve the purchase? Explain.