Olivia has just got her accounting degree and started working for Mainely Lobster Inc., a company that is known for their delicious footlong lobster rolls. Shortly after the pandemic started, the company discontinued its restaurant business. Now they focus on delivering wholesale orders of fresh lobster rolls locally and frozen lobster rolls across the country. Olivia is a management trainee in the CFO’s office, and one of her job responsibilities is to aggregate cost information for their products. She has noticed that the company has been using the traditional costing system for decades: all manufacturing overhead costs are allocated across products using a plant-wide predetermined overhead rate of $50 per direct labor hour. Olivia is very concerned with this practice, and she has mentioned to her superior that it is not appropriate for the company to use the traditional costing system, because different products require different amounts of indirect overhead resources. For example, under the traditional system all costs associated with accommodating local customers’ special requests for fresh lobster rolls are part of manufacturing overhead costs and therefore allocated across products based on direct labor hours. However, frozen lobster rolls are prepared from the preset recipe, so there are no customers’ special requests to handle. Given that traditional costing systems may result in significant cost distortions when determining products costs, Olivia’s supervisor asked her to explore the potential for implementing activity-based costing.

Olivia started with the company’s 2021 traditional income statement. In 2021, the company only had two products: fresh lobster rolls and frozen lobster rolls. She would like to compare the two products’ product margins under the activity-based costing system with their gross margins under our current traditional costing system.

Mainely Lobster
Income Statement
Year Ended December 31, 2021
Sales		$2,160,000
Cost of goods sold
Direct materials	$640,000
Direct labor	$192,000
Manufacturing overhead	$320,000	1,152,000
Gross margin		1,008,000
Selling and administrative expenses
Variable Selling expenses	224,000
Fixed Selling expenses	250,000
Total administrative expenses	160,000	634,000
Net operating income		$374,000

Currently, the company relies on a third-party carrier to deliver their frozen lobster rolls to different parts of the country. In order to streamline the storing and delivering of frozen lobster rolls that are ready to be shipped to customers, the senior management plan to invest $3 million to build a distribution center in the suburbs of Portland next year. The book value of the distribution center will be depreciated over the next 30 years. Could you help Olivia and her supervisor determine how the depreciation expense of the distribution center will affect the gross margin of the two products if the company uses the traditional costing system? If the company uses the activity-based costing system instead, how will the depreciation expense of the distribution center affect the product margin of the two products? For simplicity, assume that sales revenue and other costs remain the same next year.