Case 18-2: California Creamery[footnoteRef:1]* [1: * This teaching note was written by Kenneth A. Merchant.]

Note: This case is new for the Twelfth Edition.

Purpose of CaseThis 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.

Suggested Assignment Questions1. Compute the full production cost (per gallon) of the Polynesian Fantasy and Vanilla products using:a. Wills old costing method;b. The new costing method (Louises suggestion).

2. What are the effects, if any, of changing the companys costing method? Specifically, are the differences between the two costing methods material in terms of:a. their effect on individual product costs?b. their effect on total company profits? (Assume no changes in any operating decisions, such as prices and production volumes.)If there are material differences, why do they exist? If there are no material differences, why do they not exist?3. What should Will do now? Explain.Question 1

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).Table 1Old System Costs

Polynesian FantasyVanilla

DM2.001.80

DL1.201.20

OH2.401.20 * 200%2.401.20 * 200%

5.605.40

The new system costs took some calculating. Table 2 shows the calculation of the cost driver rates. Table 3 uses these rates to calculate the product costs. The total costs for Polynesian Fantasy and Vanilla are $9.07 and $4.64 respectively.

Table 2New SystemCalculate cost drivers

ActivityBudgeted CostActivity cost driverBudgeted activityCost driver rate

Purchasing$80,000Purchase orders909$88.01

Material handling95,000Setups1,84651.46

Blending122,000Blender hrs1,000122.00

Freezing175,000Freezer hrs1,93690.39

Packaging110,000Packaging machine hrs1,100100.00

Quality control18,000Batches28662.94

Total mfg OH cost600,000

Table 3New SystemCalculate product costsPolynesian FantasyVanilla

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

Material handling3 * (2,000/100) =603,087.763 * (100,000/2,500) =1206,175.20

Blending(36 min * 20) 60=121,464.00(18 min * 1,000) 60 =30036,600.00

Freezing1 hr * 20 =201,807.851 hr * 1,000 =1,00090,390.00

Packaging(18 min * 20) 60 =6600.00(12 min * 1,000) 60 =20020,000.00

Quality control(2,000/100) =201,258.80(100,000/2,500) =402,517.60

TOTAL OH$11,738.76TOTAL OH$164,488.80

2,000 gallons100,000 gallons

TOTAL OH per gallon5.87TOTAL OH per gallon1.64

DM2.001.80

DL1.201.20

Total cost per gallon$9.07Total cost per gallon$4.64

Question 2

Cost system designs have no effect on real product costswhatever those real costs are is not affected by what the cost accountants are doing. However, there is a material difference between the costs revealed by the two cost models. Wills understanding of reality would improve materially if he adopted the new cost system. The new cost system is a better cost model. The differing cost effects of machine times and batch sizes are averaged out in the old system. Until and unless operating decisions are changed, the effect on total company profits of switching to the new cost system would be zero. All the differences at the product level even out in the aggregate.

Question 3

With the new insights from a better cost system, 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).