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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 1 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. 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. 2 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 provided by the traditional method based one single cost pool of indirect costs and provide examples from the case that support your analysis. 4. What are the managerial implications for the revised costs?-what would you do if you were the manager of the company and why? 3 Exhibit 1 Resources Used Costs of Resources Support staff wages $30,000 Benefits and insurances 12000 Information Systems 8000 Equipment 7000 Maintenance 3000 Utilities 4000 Total $64,000 4 Exhibit 2: Traditional Income Statement Sales Material Costs Direct Labor Costs Overhead Costs @400% Total Operating Income Profit Margin Flavor A $85,000 Flavor B $50,000 Flavor C $16,500 Flavor D $3,500 Total $155,000 29000 9000 20000 4750 5000 1750 400 500 54,400 16,000 36000 19000 7000 2000 64,000 $11,000 $6,250 $2,750 $600 $20.600 13% 13% 17% 17% 13% 5 Exhibit 3:Direct costs and Activity cost drivers Production sales in units Sales in Dollars Unit selling price Unit material cost Machine hours per unit Production runs Total setup time (hours) Manage Products Flavor A 60000 Flavor B 50000 Flavor C 10000 Flavor D 2000 Total 122000 $85,000 $1.42 $50,000 $1.20 $16,500 $1.65 $3,500 $1.75 $155,000 0.48 0.4 0.5 0.2 0.1 0.1 0.1 0.1 12200 50 200 50 50 38 220 12 45 150 515 1 1 1 1 4 6