mplementing Activity$-$Based Costing $($ABC$)$

The case of a juice company

The juice company is a medium$-$sized company producing four different flavors of juice,

including two new flavors recently added on the ground they were in high demand by customers

who were willing to pay a premium for them.

Recently, under the pressure of shareholders about the poor financial performance, Grace Orland,

manager 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 $20$ per cent of profit margin.

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 tracks the direct materials consumed by 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 arbitrarily allocated to each flavor

based on direct labor cost. The rate was set at $400\%$ of direct labor costs $($see Exhibit $2).$

Grace 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

manager to question the accuracy of that costing system and to conclude that the current method

of allocation of indirect costs may be distorting their product costs thereby causing inappropriate

pricing.

The manager hires you as a cost accounting trainee to investigate the root causes of the cost

distortion and come up with actions and initiatives to address these issues. Grace promised to

provide you with all the information you may need in your undertakings.

Based on the topics you covered in your cost accounting class, you thought that Activity$-$Based

Costing $($ABC$)$ may represent a strong tool to tackle the problem.

To remedy the distortions caused by the traditional method of costing based on one single cost

pool of indirect costs, you 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

$2$

activities. After careful analysis of the company$$s operations, you 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 $3.$

You 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, you found out that their services are used by three activities: process production run

$(30\%),$ set up $(45\%),$ and the remaining $25\%$ consumed to manage products.

Next, you tackled the information system item and determines, after interview with the head of

the information system department, that process production runs accounts for $35\%$ of their

services while $65\%$ are used to manage products.

The results of your 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.

Questions

$1.$ Describe the problem the company is facing.

$2.$ Calculate the costs for the four flavors using ABC and produce the new income statement

based on ABC calculations.

$3.$ Explain why, in this case, the ABC results are different from those calculated under the

traditional method based one single cost pool of indirect costs and provide specific examples

from the case that support your analysis. Be as much specific as you can.

$4.$ What are the opportunities for cost reduction you may suggest to Grace?