Problem 5.56 Activity-Based Costing World Gourmet Coffee

Problem 5 56 Activity Based Costingworld Gourmet Coffee Company Wgcc

Problem 5 56 Activity-Based Costing World Gourmet Coffee Company (WGCC) is a distributor and processor of different blends of coffee. The company buys coffee beans from around the world and roasts, blends, and packages them for resale. WGCC currently has 15 different coffees that it offers to gourmet shops in one-pound bags. The major cost is raw materials; however, there is a substantial amount of manufacturing overhead in the predominantly automated roasting and packing process. The company uses relatively little direct labor.

Some of the coffees are very popular and sell in large volumes, while a few of the newer blends have very low volumes. WGCC prices its coffee at full product cost, including allocated overhead, plus a markup of 30 percent. If prices for certain coffees are significantly higher than market, adjustments are made. The company competes primarily on the quality of its products, but customers are price-conscious as well. Data for the 20x1 budget include manufacturing overhead of $3,000,000, which has been allocated on the basis of each product’s direct-labor cost.

The budgeted direct-labor cost for 20x1 totals $600,000. Based on the sales budget and raw-material budget, purchases and use of raw materials (mostly coffee beans) will total $6,000,000. The expected prime costs for one-pound bags of two of the company’s products are as follows: Kona Malaysian Direct material ................................................................... $3.20 $4.20 Direct labor ......................................................................... .30 .30 WGCC’s controller believes the traditional product-costing system may be providing misleading cost information. She has developed an analysis of the 20x1 budgeted manufacturing-overhead costs shown in the following chart.

ActivityCost DriverBudgeted ActivityBudgeted Cost Purchasing ................................Purchase orders ...................... 1,158 ..............$ 579,000 Material handling .....................Setups ..................................... 1,800 .................720,000 Quality control..........................Batches ................................... 720 ....................144,000 Roasting ...................................Roasting hours .........................96,100 ...............961,000 Blending ...................................Blending hours.........................33,600 ...............336,000 Packaging .................................Packaging hours ......................26,000 .............. 260,000 Total manufacturing-overhead cost .................................................................... $3,000,000 Data regarding the 20x1 production of Kona and Malaysian coffee are shown in the following table. There will be no raw-material inventory for either of these coffees at the beginning of the year. Kona Malaysian Budgeted sales ..............................................................................2,000 lb. 100,000 lb. Batch size .........................................................................................500 lb. 10,000 lb. Setups ..........................................................................................3 per batch 3 per batch Purchase order size ...........................................................................500 lb. 25,000 lb. Roasting time .......................................................................... 1 hr. per 100 lb. 1 hr. per 100 lb. Blending time ....................................................................... .5 hr. per 100 lb. .5 hr. per 100 lb. Packaging time ...................................................................... .1 hr. per 100 lb. .1 hr. per 100 lb. Required: Use WGCC’s current product-costing system and activity-based costing approach to assess the full costs. Additionally, analyze the implications for pricing strategies based on these costing methods.

Paper For Above instruction

Introduction

Costing accuracy plays a vital role in effectively managing pricing, profitability, and operational decisions within manufacturing firms. Traditionally, companies like WGCC have relied on conventional product-costing systems, primarily allocating manufacturing overhead based on direct labor costs. However, as operations become more automated and overhead becomes a significant cost component, traditional approaches may distort actual product costs, leading to suboptimal pricing and strategic decisions. This paper examines WGCC's current costing method versus an activity-based costing approach, analyzes the implications on product costing and pricing, and provides recommendations for more accurate cost management.

Assessment of WGCC’s Traditional Costing System

Using the conventional approach, WGCC allocates overhead based on direct labor costs. The total budgeted manufacturing overhead of $3,000,000 and direct labor cost of $600,000 result in a predetermined overhead rate of 5 ($3,000,000 / $600,000). Applying this rate to each product’s direct labor cost yields the following full product costs:

  • Kona Coffee: Direct materials $3.20 + Direct labor $0.30 = $3.50; Overhead at 5 times direct labor ($0.30) = $1.50; Total cost per pound = $3.50 + $1.50 = $5.00.
  • Malaysian Coffee: Direct materials $4.20 + Direct labor $0.30 = $4.50; Overhead at 5 times direct labor ($0.30) = $1.50; Total cost per pound = $4.50 + $1.50 = $6.00.

Adding a 30% markup aligns selling prices with full costs, yielding:

  • Kona: $5.00 x 1.3 = $6.50 per pound.
  • Malaysian: $6.00 x 1.3 = $7.80 per pound.

While straightforward, this method's main limitation is its potential distortion of product costs, especially for products with differing consumption of activities not proportional to labor hours. For WGCC, which automates roasting and packing, overhead may be driven by factors such as batch size, setup numbers, or machine hours rather than direct labor.

Activity-Based Costing (ABC) Approach

The ABC system assigns overhead costs based on specific activities that consume resources, as detailed in the provided activity cost pool data. For example, purchasing, material handling, quality control, roasting, blending, and packaging each have dedicated cost drivers and budgets.

Calculating activity rates:

  • Purchasing: $579,000 / 1,158 purchase orders = $500 per purchase order.
  • Material Handling (Setups): $720,000 / 1,800 setups = $400 per setup.
  • Quality Control (Batches): $144,000 / 720 batches = $200 per batch.
  • Roasting: $961,000 / 96,100 hours = approximately $10 per roasting hour.
  • Blending: $336,000 / 33,600 hours = $10 per blending hour.
  • Packaging: $260,000 / 26,000 hours = $10 per packaging hour.

Estimating costs for Kona and Malaysian coffees involves calculating the consumption of activities based on their production volumes and process times.

Cost Calculation for Kona Coffee

For Kona, producing 2,000 lbs with a batch size of 500 lbs results in 4 batches. Setups required: 3 per batch × 4 batches = 12 setups. Purchase orders are placed for 500 lbs, so two orders are needed: 4,000 lbs total, requiring 4 purchase orders.

Activities and costs:

  • Purchasing: 4 purchase orders × $500 = $2,000
  • Setups: 12 setups × $400 = $4,800
  • Quality control: 4 batches × $200 = $800
  • Roasting: 2,000 lbs / 100 lbs = 20 hours × $10 = $200
  • Blending: 20 hours × $10 = $200
  • Packaging: 2,000 lbs / 100 lbs = 20 hours × $10 = $200

Total activity-based overhead for Kona: $2,000 + $4,800 + $800 + $200 + $200 + $200 = $8,400.

Per pound overhead: $8,400 / 2,000 lbs = $4.20.

Prime cost (materials + labor): $3.20 + $0.30 = $3.50; total cost per pound using ABC: $3.50 + $4.20 = $7.70.

Cost Calculation for Malaysian Coffee

For 100,000 lbs with a batch size of 10,000 lbs, the number of batches: 10.0. Activities include:

  • Purchase orders: 4 orders (since each order is 25,000 lbs) (i.e., 100,000 / 25,000). Cost: 4 × $500 = $2,000.
  • Setups: 3 per batch × 10 batches = 30 setups. Cost: 30 × $400 = $12,000.
  • Quality control: 10 batches × $200 = $2,000.
  • Roasting: 100,000 lbs / 100 lbs = 1,000 hours × $10 = $10,000.
  • Blending: 1,000 hours × $10 = $10,000.
  • Packaging: 1,000 hours × $10 = $10,000.

Total activity-based overhead: $2,000 + $12,000 + $2,000 + $10,000 + $10,000 + $10,000 = $44,000.

Per pound overhead: $44,000 / 100,000 lbs = $0.44.

Prime cost (materials + labor): $4.20 + $0.30 = $4.50; total cost per pound using ABC: $4.50 + $0.44 = $4.94.

Implications for Pricing Strategies

The traditional costing system suggests higher full costs — $6.50 for Kona and $7.80 for Malaysian — leading to prices that may be less competitive. Conversely, the ABC approach reveals that Kona’s true overhead is approximately $7.70 per pound, and Malaysian’s is about $4.94 per pound, significantly different from the traditional estimates.

This discrepancy indicates that Kona might be undercosted under traditional methods, potentially leading to pricing that is too low and eroding profit margins. Malaysian coffee, on the other hand, might be overcosted, causing prices to be unnecessarily high and reducing competitiveness. Accurate ABC-based costs enable WGCC to set prices more precisely, aligning them with true product costs, improving margins, and maintaining competitiveness.

Conclusion

Accurate costing methods are essential for strategic decision-making. WGCC’s shift from traditional to activity-based costing reveals substantial differences in product costs, notably for high-volume and low-volume blends. Implementing ABC allows WGCC to better reflect the activities that consume resources, facilitating more informed pricing, product line decisions, and cost control measures. Ultimately, transitioning to ABC can improve profitability, competitive positioning, and operational efficiency.

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