Question

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 (C & 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.

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Answer 1

1. Actual problem , is Ohs are allocated on direct labor basis under traditional costing--even though D/L costs /unit are almost equal for flavor C & more for Flavor D , than A & B, they absorb less of total Ohs , because of lesser no.of units produced & sold.

So, both per unit & total profitability of A & B looks considerably less , than what they actually are, considering the activity-based resources consumed by them.

There is certainly an ethical issue ,in , as far as considering product-lines A & B as less-profit making, when actually, it is not the case. It is a case of wrong allocation of Ohs procedure, that need to be addressed.

2..

% of resources used	Prodn. Runs	Set-up	Manage pdts.	Run M/cs	Total OH
Support staff wages	40%	40%	20%		30000
Benefits & Insurnaces	40%	40%	20%		12000
Information systems	30%		70%		10000
Equipment				100%	7000
Maintenance	50%			50%	4000
Utilities	25%	25%	25%	25%	3000
Total	150	570	4	12200	66000

$ amt. of Resources used	Prodn. Runs	Set-up	Manage pdts.	Run M/cs	Total OH
Support staff wages	12000	12000	6000		30000
Benefits & Insurnaces	4800	4800	2400		12000
Information systems	3000		7000		10000
Equipment				7000	7000
Maintenance	2000			2000	4000
Utilities	750	750	750	750	3000
Total $ amt.	22550	17550	16150	9750	66000
Total activity units	150	570	4	12200
Cost /activity unit	150.3333	30.7895	4037.5	0.7992

From Exhibit-3-Flavor-wise
Flavor	A	B	C	D	Total
Total Machine hrs.	6000	5000	1000	200	12200
Prodn. Runs	50	50	38	12	150
Set up hrs.	150	120	200	100	570
Manage pdts.	1	1	1	1	4

Now, allocating costs to the different flavors--- from the above 2 tables
Flavor	A		B		C		D		Total
Machine hrs.	6000*0.7992=	4795.2	5000*0.7992=	3996	1000*0.7992=	799.2	200*0.7992=	159.8	9750
Prodn. Runs	50*150.3333=	7516.665	50*150.3333=	7516.665	38*150.3333=	5712.7	12*150.3333=	1804	22550
Set up hrs.	150*30.7895=	4618.425	120*30.7895=	3694.74	200*30.7895=	6157.9	100*30.7895=	3079	17550
Manage pdts.	1*4037.5=	4037.5	1*4037.5=	4037.5	1*4037.5=	4037.5	1*4037.5=	4038	16150
Total Ohs/product-wise/activity -wise		20968		19245		16707		9080	66000

As said above, Ohs are different as presented hereunder:
Summary of OH allocation	A	B	C	D	Total
Overheads as per ABC	20968	19245	16707	9080	66000
OH allocation at 400%* D/L costs	38000	20000	6000	2000	66000
Difference	-17032	-755	10707	7080	0

Based on all the above wkgs. In 2..This is because under Traditional costings Ohs are allocated, at 400% of D/L costs, whereas,

under ABC method, Ohs are allocated according to the rate of consumption of the different Ohs incurred, given the different levels of activities required by the different flavor-lines.

3. Costs & Income
Product-wise income statement
under Traditional costing						Per unit basis
Flavor	A	B	C	D	Total	A	B	C	D
Sales in units	60000	50000	10000	2000	122000
Unit selling price	1.433	1.04	1.6	1.8		1.430	1.04	1.6	1.8
Sales in $	86000	52000	16000	3600	157600
Direct material costs	28000	20000	5500	400	53900	0.467	0.400	0.550	0.200
Direct labor costs	9500	5000	1500	500	16500	0.158	0.100	0.150	0.250
OH allocation at 400%* D/L costs	38000	20000	6000	2000	66000	0.633	0.400	0.600	1.000
Total costs	75500	45000	13000	2900	136400	1.258	0.900	1.300	1.450
Operating Income	10500	7000	3000	700	21200	0.172	0.140	0.300	0.350
Profit margin(opg.income/Sales $	12%	13%	19%	19%	13%	12%	13%	19%	19%

Product-wise income statement
as per ABC analysis						Per unit basis
Flavor	A	B	C	D	Total	A	B	C	D
Sales in units	60000	50000	10000	2000	122000
Unit selling price	1.433	1.04	1.6	1.8		1.430	1.04	1.6	1.8
Sales in $	86000	52000	16000	3600	157600
Direct material costs	28000	20000	5500	400	53900	0.467	0.400	0.550	0.200
Direct labor costs	9500	5000	1500	500	16500	0.158	0.100	0.150	0.250
Overheads as per ABC	20968	19245	16707	9080	66000	0.349	0.385	1.671	4.540
Total costs	58468	44245	23707	9980	136400	0.974	0.885	2.371	4.990
Operating Income	27532	7755	-7707	-6380	21200	0.456	0.155	-0.771	-3.190
Profit margin(opg.income/Sales $	32%	15%	-48%	-177%	13%	32%	15%	-48%	-177%

ABC method of allocation is more appropriate as it gives weightage to the different levels of resource-consumption, instead of burdening the product-line with a flat overall % age.

4. John Orland needs to know his costs accurately , so as to set the correct selling price---so that he can compete in the market profitably.

Also , he needs to ensure about the continued market demand for all the flavors, especially the new ones, C&D , as they seem to consume more production runs & set-up time

Profit-making by optimisation of resources used , should be his aim.

5.Currently, by introducing both C & D the company'is making losses at the operating level.

They consume finance in the form of materials, labor & resources that could otherwise be used , for production of A & B losses.--so there is opportunity cost of profit lost, by not producing A & B and diverting finances to these loss-making lines--as seen by the income statement as per ABC method.

Also,on the marketing side, efforts are being mis-directed , in selling C & D lines, in the place of A & B lines.

So, it is advisable to discontinue C & D flavors and concentrate on A & B flavors only.