AFM102 Lecture Notes - Lecture 9: Diversity Training, Cost Driver
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John Orland, controller of the JuiceCompany, has been concerned over the erosion of the recentfinancial 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 salesmanager has expanded the lines of products to encompass new flavors(D & C) which were in high demand by customers who were willingto pay 5 to 10 % premium.
Richard Dunn, the manufacturingmanager, was also excited to introduce the new flavors since theywere expected to generate higher margins while using the sametechnology as standard flavors. However, he noticed that theintroduction of new flavors added some technical complexities tothe 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 wereproduced in smaller batches but required more changeovers and moreproduction runs (see Exhibit 3).
The Juice Company produced thedifferent flavors in the same factory. Each flavor had a bill ofmaterials that determines the quantity and cost of direct materialsused for the production of each flavor. Additionally, a routinesheet was used to track the direct labor expenses incurred at eachoperating step for each of the four flavors. All overhead costswere grouped at the plant level and allocated to each flavor on thebasis of direct labor cost. The rate was arbitrarily set at 400 %of direct labor costs (see Exhibit 2).
John was intrigued by the behaviorof their main competitors who were more interested in competing inlow margin flavors (A and B) than in high profit margins (Flavors C&D). Such behavior has led the controller to question theaccuracy of the costing system used by the company and to concludethat the current method of allocation of indirect costs isdistorting their productsâ costs thereby causing inappropriatepricing.
To remedy the distortions caused bythe traditional method of costing based on one single cost pool ofindirect costs, John decided to implement activity-based costing(ABC) method which focuses on the activities, how they areperformed, and the resources they consumed and to assign activitiescosts to products based on how much demand each of these productsputs on these activities. After careful analysis of themanufacturing operations of the company and input from engineers aswell as manufacturing and operating managers, the controlleridentified four main activities: process production run, set upequipment, manage products, and run machines.
The demand on these activities bydifferent flavors is illustrated in Exhibit 3.
In order to determine the costsincurred to perform these various activities, he began byidentifying the resources that were being consumed by theseactivities. These resources were then grouped in six categories asshown in Exhibit 1. To gather the required new cost information, heproceeded to interview the department heads in charge of supportstaff wages and benefits and insurance; he found out that theirservices are used by three activities: process production run(35%), set up (35%), and the remaining 30 % consumed to manageproducts.
Next, the controller tackled theinformation system item and determines, after interview with thehead of the information system department, that process productionruns accounts for 25 % of their services while 75 % are used tomanage products.
The results of his investigationsabout the usage of the equipment revealed that it was entirely usedto run machines. Maintenance services were shared equally betweenthe 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 bythe traditional method based one single cost pool of indirectcosts.
What are the managerial implications for the revised estimates?(i.e.,What would you do if you were the manager of the company andwhy?)
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 |
