Page 1

Date: April 1, 2014 To: Mr. Charles Bialetti, President of Java Source Inc. From: Melody Ng, Consultant Subject: Using Activity Based Costing (ABC) instead of Traditional Costing System Dear Mr. Bialetti, Analysis of the current traditional costing system showed that costs for Kenya Dark and Viet Select are not allocated well because the gross margin is overstated. By using ABC, the unit product cost will be more accurate. Because the production process contains multiple activity drivers and the number of units produced varies between the two products, ABC is the better costing method. The production process for the two products are complex as shown by six different activities: purchasing, material handling, quality control, roasting, blending, and packaging. Due to the number of different activities, ABC allocates the product’s total manufacturing overhead (MOH) costs better because the costs are assigned based on the activity usage from each of the six activities as seen in figures 1, 2a, and 2b. Viet Select’s unit MOH cost is more than five times Kenya Dark’s unit MOH cost. Compared to ABC, the traditional costing system allocates MOH costs according to only one cost driver, direct labor hours. However, MOH costs are not caused by direct labor hours since the two products require the same 0.02 labor hours. In addition to the complex production process, the number of units produced varies for the two products with Kenya Dark producing 76,000 more pounds than Viet Select as seen in figure 5. When there are differences in the number of units produced, traditional costing overcosts the product with the higher number of units. As seen in figure 3, Kenya Dark’s unit product cost is higher than Viet Select because of the difference in the number of units produced. By using traditional costing, it seems that Viet Select is making a gross margin of $1.01 when it is actually selling at a loss of $0.01 under ABC. In figure 4, Kenya Dark’s and Viet Select’s unit product costs are similar at approximately $5.00, so ABC is more accurate in assigning product costs. Because ABC assigns product costs better, it presents the gross margin more accurately by showing that Viet Select has a loss of $0.01. Due to the gross margin loss, Java Source should reconsider its pricing scheme of Viet Select or discontinue it. Furthermore, Java Source should reconsider its pricing of Kenya Dark to make it competitive in the market since there is a gross margin of $1.95. ABC does a better job of allocating costs when there is a complex production process consisting of several activities and a large difference in units produced. Switching to ABC will benefit Java Source because the gross margin will be better represented for each of the two products. Viet Select’s gross margin loss affects JSI’s profitability and it should be discontinued or repriced. Please contact me with any questions that you may have about the analysis or the next steps. Sincerely, Melody Ng


Appendix Figure 1

MOH Activity Cost Drivers and Activity Rates in JSI (ABC) Purchasing a. Total MOH Costs b. Total amount of activity Activity rate (a÷b)

$560,000 2,000 orders $280 per order

Material Handling $193,000 1,000 setups $193 per setup

Quality Control $90,000 500 batches $180 per batch

Roasting

Blending

Packaging

$1,045,000 95,000 hours $11 per hour

$192,000 32,000 hours $6 per hour

$120,000 24,000 hours $5 per hour

Figure 2a

Total Manufacturing Overhead Costs Assigned for Kenya Dark (ABC) Purchasing a. Activity rate b. Activity usage for Kenya Dark Total MOH assigned for each activity (a×b)

Quality control $180 per batch 16 batches

Packaging

Blending

Roasting

$280 per order 4 orders

Material handling $193 per setup 32 setups

$11 per hour 240 hours

$6 per hour

$5 per hour

400 hours

1,200 hours

$1,120

$6,176

$2,880

$13,200

$2,400

$1,200

c. Total MOH * d. Number of pounds MOH unit product cost (c÷d)

*Total MOH = Total MOH assigned for purchasing + total MOH assigned for material handling + total MOH assigned for quality control + total MOH assigned for packaging + total MOH assigned for blending + total MOH assigned for roasting

$29,976 80,000 $0.34

Figure 2b

Total Manufacturing Costs Assigned for Viet Select (ABC) Purchasing a. Activity rate b. Activity usage Total MOH assigned for each activity (a×b)

Quality control $180 per batch 8 batches

Packaging

Blending

Roasting

$280 per order 8 orders

Material handling $193 per setup 16 setups

$11 per hour 12 hours

$6 per hour

$5 per hour

20 hours

60 hours

$2,240

$3,088

$1,440

$660

$120

$60

*Total MOH = Total MOH assigned for purchasing + total MOH assigned for material handling + total MOH assigned for quality control + total MOH assigned for packaging + total MOH


Appendix c. Total MOH d. Number of pounds MOH unit product cost (c÷d)

$7,608 4,000 $1.90

Figure 3

Gross Margin Breakdown Under Traditional Costing for Coffee Products Kenya Dark $7.03 $5.62 $1.41

a. Selling price (b×1.25) b. Product cost Gross margin (a – b)

Viet Select $5.03 $4.02 $1.01

Figure 4

Gross Margin Breakdown Under Activity Based Costing for Coffee Products Kenya Dark $7.03 $5.08 $1.95

a. Selling price b. Product cost Gross margin (a – b)

Viet Select $5.03 $5.04 $(0.01)

Figure 5

Units Produced of Kenya Dark and Viet Select 90,000

Units Produced (Pounds)

80,000

80,000

70,000 60,000 50,000 40,000 30,000 20,000 10,000

4,000

0 Kenya Dark

Viet Select

Coffee Products

Memo  
Read more
Read more
Similar to
Popular now
Just for you