Introduction

14 retail ice cream stores are spread throughout Southern California, from San Luis

Obispo to San Diego.It is sold only the highest quality, ultra premium ice cream and

offers 25 different ice cream flavor. Many of the flavors were “exotic" like“Polynesian

Fantasy,” “Mango-Lemon Supreme,” and “Multi-Nut Twist.” A few of the exotic flavors

sold in low volumes. California Dreamery Inc also sold a few traditional ice cream

flavors: vanilla, chocolate, strawberry, and coffee. Earlier ice cream was produced in the

garage of the company’s founder, Will Forgey.

California creamery Inc use of automated manufacturing equipment that blended the

flavors and packaged the liquid ice cream in preparation for freezing. The most

significant production costs: raw materials, particularly cream, sugar, and the special

flavor ingredients, and for the acquisition, operation and maintenance of the production

equipment. Prices are set to yield, roughly, a markup of 100% on average full production

costs. Manufacturing overhead of $600,000 (2010 budget). A proportion of the direct

labor used in the production process. Total direct labor costs for 2010 was $300,000. It is

charged the overhead to products at a rate of 200 % of direct labor costs. All products

were sold at the same retail price.

Problem Analysis This case provides a simple setting that illustrates activity-based cost (ABC) principles

and the effects that such a system can have. It can be used as an exam case when the

examination period is short. Students who understand ABC principles well can read the

case and answer a basic set of questions in one hour.

Question No. 1Compute the full production cost (per gallon) of the Polynesian Fantasy and Vanilla

products using:

a) Will’s old costing method;

b) The new costing method (Louise’s suggestion).

Under the old system, the only difference shown between the costs of Polynesian Fantasy

and Vanilla ice creams was due to the $.20 difference in direct material costs (see Table

1). The overhead rate was 200% of direct labor dollars ($600,000 ÷ $300,000).

Figure 1: Old System Costs

Polynesian Fantasy VanillaDM 2.00 1.80DL 1.20 1.20OH 2.40

1.20 * 200% 2.40

1.20 * 200%

5.60 5.40

The new system costs took some calculating. Figure 2 shows the calculation of the cost

driver rates. Figure 3 uses these rates to calculate the product costs. The total costs for

Polynesian Fantasy and Vanilla are $9.07 and $4.64 respectively.

Figure 2: New System—Calculate cost drivers

Activity Budgeted Cost

Activity cost driver

Budgeted activity

Cost driver rate

Purchasing $80,000 Purchase orders 909 $88.01Material

handling95,000 Setups 1,846

51.46Blending 122,000 Blender hrs 1,000 122.00Freezing 175,000 Freezer hrs 1,936 90.39Packaging 110,000 Packaging machine

hrs1,100

100.00

Quality control

18,000 Batches 28662.94

Total mfg OH cost

600,000

Figure 3: New System—Calculate product costsPolynesian Fantasy Vanilla

Purchasing (2,000/50) = 40 $3,520.40 (100,000/1,000) = 100 $8,801.00Material handling

3 * (2,000/100) = 60 3,087.76

3 * (100,000/2,500) = 120 6,175.20

Blending (36 min * 20) 60= 12 1,464.00

(18 min * 1,000) 60 = 300 36,600.00

Freezing 1 hr * 20 = 20 1,807.85 1 hr * 1,000 = 1,000 90,390.00Packaging (18 min * 20)

60 = 6 600.00(12 min * 1,000) 60 = 200 20,000.00

Quality control (2,000/100) = 20 1,258.80 (100,000/2,500) = 40 2,517.60

TOTAL OH $11,738.76

TOTAL OH $164,488.80

2,000 gallons

100,000 gallons

TOTAL OH per gallon 5.87

TOTAL OH per gallon 1.64

DM 2.00 1.80DL 1.20 1.20Total cost per gallon $9.07

Total cost per gallon $4.64

Question No.2

What are the effects, if any, of changing the company’s costing method? Specifically, are

the differences between the two costing methods material in terms of:

a) Their effect on individual product costs?

The change in company's costing method will be most likely impact the costs of each

individual product. How the California Creamery allocate its overhead costs across its

product portfolio will have an impact on the company's product. It is Mix and pricing

strategy. The current costing method that Will is currently using is simple but not accurate

as it pictures the wrong description on the profitability of a product, as the overhead cost's

allocation is based on consumption Direct Labour hours for a product, whereas base on

the reality overhead cost is created based on individual activities which may or may not

directly proportionate to the Direct Labour costs.

The ABC method gives both accurate description of the costs and product's profitability

Instead of placing the Direct Labour as the product base, the ABC method divides the

Overhead costs into various activities based on activity's consumption in producing the

product (e.g. Quality Overhead costs are allocated based in 'Number of batches' of the

product base).

b) Their effect on total company profits? (Assume no changes in any operating decisions,

such as prices and production volume)

If there are material differences, why do they exist? If there are no material differences,

why do they not exist?

There will be no any effect in the total of the company profit by the change in company's

costing method as the whole as costing is an internal process of profitability of a number

of product will be compensated by a decrease in others.

Question No.3

What should Will do now? Explain.

Will should implement the ABC method even though this does not increase the overall

profit of the company. The ABC method will be able to help him to closely analysing the

costs associated with each individual product to improve the manufacturing process and

efficiency which Will then increase the company's profitability. Will might usefully take

any of a number of actions, affecting such areas as cost system design, product offerings,

prices and promotions, product designs, and manufacturing processes (e.g., batch sizes).

The ABC method gives Will the exact cost of each of individual product which can be

used to project future strategy for Marketing product mix, marketing effort and

profitability. Will have the details of Overhead costs as well as the cost driver, the

company have multiple products which consume the same overhead, produces in

batches; which fulfilled the requirement of using ABC method. The monitoring of

implemented ABC method will required in order to examine the profitability of each

product.

Conclusion

As a conclusion, Will should implement the ABC method even though this does not

increase the overall profit of the company. The ABC method will be able to help him to

closely analysing the costs associated with each individual product to improve the

manufacturing process and efficiency which Will then increase the company's

profitability.