Aunt Allee’s Jams and Jellies was founded by Allee Glover and her husband Mang

Question

Aunt Allee’s Jams and Jellies was founded by Allee Glover and her husband Mangrum in the

kitchen of their modest farm in 1958. The original products that were produced by the

company were cherry jam and cherry jelly, using an old family recipe and fruit grown on the

family farm. As demand grew, cherries were bought from local farms (all within 50 miles of

the factory).

By 2008 the business had grown to occupy a modest 20,000-square-foot factory/office

building on the site of the old farm. In 2008 the company was still family owned and was

operated by four of the founder’s grandchildren. Hobb Glover is the company’s president. He

manages the business and generally helps out in the office as needed. His sister, Amanda

Smith, does the marketing and selling of the products. Their cousin, Conrad Glover, is the

business’s accountant and materials manager. Another cousin, Edith Woods, is the production

and maintenance and engineering manager.

By 2001 demand for the cherry jam and jelly had outstripped the company’s ability to

produce enough jam and jelly from fresh fruit in season. Production was converted to using

concentrates and frozen cherries—but all from locally grown fruit. In 2006 the current plant

was built with the idea that the company would diversify its product line by introducing two

new jams, white grape and blueberry, and a new jelly, white grape, using other fruits

available in the state. Test marketing had shown all three products to be popular, and each

could command a premium price with higher markups than the current cherry products.

The new products were introduced in late 2006 and were in full production throughout

2007. The family was pleased that the new jams and jellies performed as well as forecast. They were also pleased that the sales of the

cherry jelly and jam were not depressed by the sales of the new products. Unfortunately, the financial results (Table 52-1) were

disappointing since traditionally the company has achieved an average of 43% return on

sales.

The factory is operating near capacity, so some decisions need to be made on next year’s

production. In January 2008, Hobb calls a meeting with Amanda, Conrad, and Edith to

discuss the financial results and decide on what needs to be done.

Hobb opens the meeting with a review of the company’s current financial situation.

While return on sales are only slightly lower than before plant expansion, the increased profit

from the new products was being counted on to pay the loan on the new building. Hobb and

Conrad do not believe that the company can afford to expand again for at least three more

years.

Amanda reports that she has been looking at extensions to the product line. The current

products are meeting demand, and she does not believe that demand will increase

substantially. She has identified two additional jams which can be sold in quantities similar to

blueberry and which should return similar margins. She recommends cutting back on cherry

jelly production, if necessary, in order to fill all the orders she can generate for the higher

margin items.

Edith reports that the new products cause several problems in production. The main

problem is in the setup of the production run. In the past, setups were relatively painless.

Since both products were the same color and flavor, changing over to run a different product

was just a matter of emptying and sanitizing the lines. With the current products, when

flavors are changed, an extensive changeover is required. Where in the past setups took less

than 30 minutes, they now take more than an hour, depending on the product to be produced,

because some changeovers require more cleaning and sanitizing between products. She has

had to increase hours worked per day to 10 to offset the setups. Edith has so far kept the

workweek to four days with no overtime but warns that the limit has been reached with the

current crew size. Another shift will be necessary if demand increases.

Conrad reports similar problems in the production control and the accounts payable

functions. He reminds the management team that they have had to add one person to the

office to support the additional support work required by the diversification in the product

line. The additional workload is being caused by more items needing to be tracked, such as

labels, fruit, and additional ingredients; more payments to be processed to the fruit growers;

and more invoices to check. While Conrad is happy with the sales and apparent markups

achieved by the new products, he openly wonders if the current costing system (where

overhead allocations are based on dollar sales) is misrepresenting the true costs and thus the

true returns on the new items. Conrad suggests reanalyzing the costs based on activity-based

costing.

The management team agrees that it is difficult to make decisions if there is concern

about the cost system, especially from the head of accounting. Conrad and Edith are tasked

with looking into what the five products are really costing Aunt Allee’s Jams and Jellies.

As a first step, Conrad and Edith tabulate production requirements and production rates

(see Table 52-2). Edith notes that the batch size differences are caused by the size of the

different kettles used for each product. Edith also notes that the reason for the different setup

times is the difference in the ease of doing the clean-out required between batches. During

setup, three people of the four-person crew work on setup while the fourth attends to

preventive maintenance and other indirect labor activities. During processing, four members

of the crew are needed.

As a second step, Conrad and Edith look at the overhead dollars. Conrad notes that the

overhead rate was just over 11% of sales two years earlier. The overhead is broken down into

five categories (see Table 52-3). The remaining expenses (the salaries of the cousins, the

depreciation of the building and equipment, etc.) are considered period costs in Aunt Allee’s

Jams and Jellies accounting system.

Conrad explains that the indirect labor includes all the hours of the four-person

production crew not charged as direct labor. They are all paid $12.50 per hour and work 2000

hours per year. Conrad and Edith agree that the indirect labor hours of the four-person crew is

either setup labor or maintenance. The indirect labor is largely driven by the hours that the

machines are in use, which is equivalent to the direct labor hours.

Fringe benefits are based on wages and amount to an additional 40% (insurance, FICA,

benefits, etc). They can be allocated among the products based on direct labor hours. Machine

maintenance costs are directly related to machine use, which can be tracked by the number of

units produced. Cleaning supplies and disposable parts are used during the setup of the

processing line. Usage is reasonably proportional to the number of setups (which is equal to

the number of batches produced).

Energy costs are most directly related to the number of units produced. The scrap costs

are directly related to setup, and usually amount to 5% of the value of materials.

Indirect materials are mainly shipping supplies. Their consumption is a based on orders

shipped. As an order can be a mix of products and can be of varying quantities of product,

Conrad does not see an easy cost driver. Since it is a relatively minor sum, he figures that

sales volume is as good a method of allocation as any other.

Conrad estimates that the office workload is the same for cherry jelly, cherry jam, white

grape jelly, and white grape jam. The workload (parts administration) caused by blueberry

jam is 1.25 times as high as for any of the other products, due to supplier issues. The office

worker makes the same pay rate as the production workers.

Based on the activity-based costs, what margin is each product achieving? Should Aunt

Allee’s Jams and Jellies expand their product line to include more low-volume specialty jams

and jellies?

Explanation / Answer

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.

Let's discuss activity based costing by looking at two products manufactured by the same company. Product 124 is a low volume item which requires certain activities such as special engineering, additional testing, and many machine setups because it is ordered in small quantities. A similar product, Product 366, is a high volume product—running continuously—and requires little attention and no special activities. If this company used traditional costing, it might allocate or "spread" all of its overhead to products based on the number of machine hours. This will result in little overhead cost allocated to Product 124, because it did not have many machine hours. However, it did demand lots of engineering, testing, and setup activities. In contrast, Product 366 will be allocated an enormous amount of overhead (due to all those machine hours), but it demanded little overhead activity. The result will be a miscalculation of each product's true cost of manufacturing overhead. Activity based costing will overcome this shortcoming by assigning overhead on more than the one activity, running the machine.

Activity based costing recognizes that the special engineering, special testing, machine setups, and others are activities that cause costs—they cause the company to consume resources. Under ABC, the company will calculate the cost of the resources used in each of these activities. Next, the cost of each of these activities will be assigned only to the products that demanded the activities. In our example, Product 124 will be assigned some of the company's costs of special engineering, special testing, and machine setup. Other products that use any of these activities will also be assigned some of their costs. Product 366 will not be assigned any cost of special engineering or special testing, and it will be assigned only a small amount of machine setup.

Activity based costing has grown in importance in recent decades because (1) manufacturing overhead costs have increased significantly, (2) the manufacturing overhead costs no longer correlate with the productive machine hours or direct labor hours, (3) the diversity of products and the diversity in customers' demands have grown, and (4) some products are produced in large batches, while others are produced in small batches.

Let’s illustrate the concept of activity based costing by looking at two common manufacturing activities: (1) the setting up of a production machine for running batches of products, and (2) the actual production of the units of product.

We will assume that a company has annual manufacturing overhead costs of $2,000,000—of which $200,000 is directly involved in setting up the production machines. During the year the company expects to perform 400 machine setups. Let’s also assume that the batch sizes vary considerably, but the setup efforts for each machine are similar.

The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups per year). Under activity based costing, $200,000 of the overhead will be viewed as a batch-level cost. This means that $200,000 will first be allocated to batches of products to be manufactured (referred to as a Stage 1 allocation), and then be assigned to the units of product in each batch (referred to as Stage 2 allocation). For example, if Batch X consists of 5,000 units of product, the setup cost per unit is $0.10 ($500 divided by 5,000 units). If Batch Y is 50,000 units, the cost per unit for setup will be $0.01 ($500 divided by 50,000 units). For simplicity, let’s assume that the remaining $1,800,000 of manufacturing overhead is caused by the production activities that correlate with the company’s 100,000 machine hours.

For our simple two-activity example, let's see how the rates for allocating the manufacturing overhead would look with activity based costing and without activity based costing:

Next, let's see what impact these different allocation techniques and overhead rates would have on the per unit cost of a specific unit of output. Assume that a company manufactures a batch of 5,000 units and it produces 50 units per machine hour, here is how the cost assigned to the units with activity based costing and without activity based costing compares:

If a company manufactures a batch of 50,000 units and produces 50 units per machine hour, here is how the cost assigned to the units with ABC and without ABC compares:

As the tables above illustrate, with activity based costing the cost per unit decreases from $0.46 to $0.37 because the cost of the setup activity is spread over 50,000 units instead of 5,000 units. Without ABC, the cost per unit is $0.40 regardless of the number of units in each batch. If companies base their selling prices on costs, a company not using an ABC approach might lose the large batch work to a competitor who bids a lower price based on the lower, more accurate overhead cost of $0.37. It’s also possible that a company not using ABC may find itself being the low bidder for manufacturing small batches of product, since its $0.40 is lower than the ABC model of $0.46 for a batch size of 5,000 units. With its bid price based on manufacturing overhead of $0.40—but a true cost of $0.46—the company may end up doing lots of production for little or no profit.

Our example with just two activities (production and setup) illustrates how the cost per unit using the activity based costing method is more accurate in reflecting the actual efforts associated with production. As companies began measuring the costs of activities (instead of focusing on the accountant’s departmental classifications), they began using ABC cost information to practice activity based management. For example, with the cost of setting up a machine now being measured and discussed, managers began to ask questions such as:

Why is the cost of setting up a production machine so expensive?
What can be done to reduce the setup cost?
If the setup costs cannot be reduced, are the selling prices adequate to cover all of the company’s costs—including the setup cost that was previously buried in the overall machine-hour overhead rate?

Definition of 'Activity-Based Costing - ABC'

An accounting method that identifies the activities that a firm performs, and then assigns indirect costs to products. An activity based costing (ABC) system recognizes the relationship between costs, activities and products, and through this relationship assigns indirect costs to products less arbitrarily than traditional methods.

'Activity-Based Costing - ABC'

Some costs are difficult to assign through this method of cost accounting. Indirect costs, such as management and office staff salaries are sometimes difficult to assign to a particular product produced. For this reason, this method has found its niche in the manufacturing sector

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.

Let's discuss activity based costing by looking at two products manufactured by the same company. Product 124 is a low volume item which requires certain activities such as special engineering, additional testing, and many machine setups because it is ordered in small quantities. A similar product, Product 366, is a high volume product—running continuously—and requires little attention and no special activities. If this company used traditional costing, it might allocate or "spread" all of its overhead to products based on the number of machine hours. This will result in little overhead cost allocated to Product 124, because it did not have many machine hours. However, it did demand lots of engineering, testing, and setup activities. In contrast, Product 366 will be allocated an enormous amount of overhead (due to all those machine hours), but it demanded little overhead activity. The result will be a miscalculation of each product's true cost of manufacturing overhead. Activity based costing will overcome this shortcoming by assigning overhead on more than the one activity, running the machine.

Activity based costing recognizes that the special engineering, special testing, machine setups, and others are activities that cause costs—they cause the company to consume resources. Under ABC, the company will calculate the cost of the resources used in each of these activities. Next, the cost of each of these activities will be assigned only to the products that demanded the activities. In our example, Product 124 will be assigned some of the company's costs of special engineering, special testing, and machine setup. Other products that use any of these activities will also be assigned some of their costs. Product 366 will not be assigned any cost of special engineering or special testing, and it will be assigned only a small amount of machine setup.

Activity based costing has grown in importance in recent decades because (1) manufacturing overhead costs have increased significantly, (2) the manufacturing overhead costs no longer correlate with the productive machine hours or direct labor hours, (3) the diversity of products and the diversity in customers' demands have grown, and (4) some products are produced in large batches, while others are produced in small batches.

Activity Based Costing with Two Activities

Let’s illustrate the concept of activity based costing by looking at two common manufacturing activities: (1) the setting up of a production machine for running batches of products, and (2) the actual production of the units of product.

We will assume that a company has annual manufacturing overhead costs of $2,000,000—of which $200,000 is directly involved in setting up the production machines. During the year the company expects to perform 400 machine setups. Let’s also assume that the batch sizes vary considerably, but the setup efforts for each machine are similar.

The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups per year). Under activity based costing, $200,000 of the overhead will be viewed as a batch-level cost. This means that $200,000 will first be allocated to batches of products to be manufactured (referred to as a Stage 1 allocation), and then be assigned to the units of product in each batch (referred to as Stage 2 allocation). For example, if Batch X consists of 5,000 units of product, the setup cost per unit is $0.10 ($500 divided by 5,000 units). If Batch Y is 50,000 units, the cost per unit for setup will be $0.01 ($500 divided by 50,000 units). For simplicity, let’s assume that the remaining $1,800,000 of manufacturing overhead is caused by the production activities that correlate with the company’s 100,000 machine hours.

For our simple two-activity example, let's see how the rates for allocating the manufacturing overhead would look with activity based costing and without activity based costing:

With ABC
Without ABC
Mfg overhead costs assigned to setups $200,000 $–0– Number of setups 400 Not applicable Mfg overhead cost per setup $500 $–0–
Total manufacturing overhead costs $2,000,000 $2,000,000 Less: Cost traced to machine setups 200,000 –0– Mfg O/H costs allocated on machine hours $1,800,000 $2,000,000 Machine hours (MH) 100,000 100,000 Mfg overhead costs per MH $18 $20
Mfg Overhead Cost Allocations $500 setup cost per batch + $18 per MH $20 per MH

Next, let's see what impact these different allocation techniques and overhead rates would have on the per unit cost of a specific unit of output. Assume that a company manufactures a batch of 5,000 units and it produces 50 units per machine hour, here is how the cost assigned to the units with activity based costing and without activity based costing compares:

With ABC
Without ABC
Mfg overhead for setting up machine $500 $–0– No. of units in batch 5,000 Not applicable Mfg O/H caused by Setup – Per Unit $0.10 Not applicable
Mfg overhead costs per machine hour $18 $20 No. of units produced per machine hour 50 50 Mfg O/H caused by Production – Per Unit $0.36 $0.40
Total Mfg O/H Allocated – Per Unit $0.46 $0.40

If a company manufactures a batch of 50,000 units and produces 50 units per machine hour, here is how the cost assigned to the units with ABC and without ABC compares:

With ABC
Without ABC
Mfg overhead for setting up machine $500 $–0– No. of units in batch 50,000 Not applicable Mfg O/H caused by Setup – Per Unit $0.01 Not applicable
Mfg overhead costs per machine hour $18 $20 No. of units produced per machine hour 50 50 Mfg O/H caused by Production – Per Unit $0.36 $0.40
Total Mfg O/H Allocated – Per Unit $0.37 $0.40

As the tables above illustrate, with activity based costing the cost per unit decreases from $0.46 to $0.37 because the cost of the setup activity is spread over 50,000 units instead of 5,000 units. Without ABC, the cost per unit is $0.40 regardless of the number of units in each batch. If companies base their selling prices on costs, a company not using an ABC approach might lose the large batch work to a competitor who bids a lower price based on the lower, more accurate overhead cost of $0.37. It’s also possible that a company not using ABC may find itself being the low bidder for manufacturing small batches of product, since its $0.40 is lower than the ABC model of $0.46 for a batch size of 5,000 units. With its bid price based on manufacturing overhead of $0.40—but a true cost of $0.46—the company may end up doing lots of production for little or no profit.

Our example with just two activities (production and setup) illustrates how the cost per unit using the activity based costing method is more accurate in reflecting the actual efforts associated with production. As companies began measuring the costs of activities (instead of focusing on the accountant’s departmental classifications), they began using ABC cost information to practice activity based management. For example, with the cost of setting up a machine now being measured and discussed, managers began to ask questions such as:

Why is the cost of setting up a production machine so expensive?
What can be done to reduce the setup cost?
If the setup costs cannot be reduced, are the selling prices adequate to cover all of the company’s costs—including the setup cost that was previously buried in the overall machine-hour overhead rate?

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