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Thursday, May 31, 2012

Costing System

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1. Costing System

1.1 Illustrate the costing system currently used by Devon Quality in Cost Centre

The costing system currently used by Devon Quality Dairy in the Cost Centre is a traditional costing system this is because in this case study Devon Quality Dairy are allocating there expenses to products using volume based drivers. In this case study, the resources consumed by Devon’s Cost Centre are depreciation, labour, utilities and other, which are all of the costs that have been incurred in production that cannot be traced directly to the products.

The traditional costing system uses a single plantwide overhead rate based on output volume to allocate factory overhead costs to the products. The factory overhead rate is total factory overhead divided by the cost driver. In this case the cost driver is pounds of butterfat. The pounds of butterfat sold are chosen as the cost driver for Devon’s because the pounds of butterfat are attributed to Devon’s purchase costs, which were indicated in the information in the article.

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1. Comment on the appropriateness of “pounds of butterfat” as an allocation base for the overhead costs in Cost Centre . Would you suggest a different allocation base?

Pounds of Butterfat as an allocation base for the overhead costs in Cost Centre aren’t very appropriate. This is because the costs in Cost Centre don’t actually reflect the specific activities that are performed or costs in this cost centre. In Cost Centre , the overhead costs are depreciation, labour and utilities. These overhead costs have absolutely no correlation with the amount of pounds of butterfat used per product. Depreciation expense is incurred from the devaluation of the factories machinery, labour is used to operate and maintain this machinery, and utilities are all of the utility costs that are incurred by the factory within their daily operations.

It is because of this that we believe that Devon should use a different allocation base, and that base should be annual batches produced. We believe that annual batches produced will be a far better allocation base because from these batches you are able effectively determine the actual volume of ice creams mix that is produced by Devon Quality Dairy.

Knowing the annual batches that are produced are a far better method of cost allocation because this cost driver actual does reflect the indirect costs that are incurred by Devon. Depreciation, labour and utilities are directly correlated to the amount of batches that are produced, because the more batches that are produced the more the cost are going to increase.

Therefore, we deem that Devon Quality Dairy would be far advantaged if they were to change there cost driver from the pounds of butterfat, to batches produced annually.

1. Reconstruct the cost allocation formula for the overhead rates shown in Table .

Factory Overhead Rate = Total Factory Overhead

Annual Batches Produced



= 61860

000



= $180.1 per batch



Delivery Overhead Rate = Total Delivery Cost

Annual Batches Produced



= 108400

000



= $54.0 per batch



Selling and Administration

Overhead Costs = Total Selling and Admin Costs

Annual Batches Produced



= 600

000



= $146.80 per batch

. McDonald’s Order

.1 What are the relevant costs to this order?

Relevant cost are defined as costs that change under two or more decision alternatives, thus the relevant costs associated with the McDonalds order are

The required purchase of additional refrigerated delivery trucks

Extra gas and maintenance cost for the trucks equalling $000 per truck per summer months.

Five additional summer drivers, costing $500 per month per driver through out the summer months

Therefore the relevant costs are

Direct Costs (1,000,000$1.607) = $ 1,607,000

Indirect Costs (1,000,000(0.17+0.11+0.014)) = $ 78,000

Additional Truck Costs (150,000) = $ 450,000

Extra Gas and Maintenance Costs (,000) = $ 18,000

Additional Summer Drivers (,5005) = $ 5,500

Total Relevant Costs for McDonalds Order = $ ,405,500

. Should the order be accepted?

To determine if we will accept this McDonalds order, we need to find out what the unit contribution margin is for this special offer.

Unit Contribution Margin = Unit Sales Price - Unit Variable Cost

McDonalds Order

Unit Sales Price 1.4

less Unit Variable Costs

Direct Costs 1.607

Indirect Costs 0.78 1.885

Unit Contribution Margin 0.055

From these calculations we found that the McDonald’s Order will produce a positive contribution margin of $0.055 per unit. Meaning that for this order Devon would receive a contribution margin of $55,000 (0.0551,000,000). Therefore, we believe that Devon Quality Dairy should accept the McDonald’s Order.

. Will your decision change if all orders have to yield the desired target of 15% mark-up?

McDonalds Order with 15% Mark-up

Unit Sales Price 1.4

less Unit Variable Costs

Direct Costs 1.607

Indirect Costs 0.78

15% Mark-up 0.8 .168

Unit Contribution Margin -0.8

From these calculations we found that the McDonald’s order with the 15% mark-up will produce a negative contribution margin of -$0.8 per unit. Meaning that from this order Devon would receive a contribution margin of -$8,000

(-0.81,000,000). Therefore, our decision would change if all orders had to yield the desired target of 15%. When the 15% mark-up is desired we would advise Devon not to accept the order.

4.4 Identify any qualitative issues that should be considered prior to accepting this order.

The first issue that Devon Quality Dairy has to consider is weather the extra mast order of 1,000,000 gallons would cause a strain on the quality of the product? Even though the new equipment enables the company to double its packaging capacity but the production process still remains the same and with the sudden new product requirement would this set the quality of the products back.

They will have to determine if the other departments such as the quality control can cope with the increase number of productions.

They will need to evaluate if they would need to increase their services from the administrative department, as they will have to take up new ordering processes for this new contract. This could also result in unseen future costs that might be involved, with a new ordering system.

An important issue that Devon should consider is how their existing managers will react to the special price they are offering to McDonalds? Currently they are charging their existing customers $.11 per gallon but if they accept the McDonalds order they will be charging them only$1.4 per gallon.

A problem could also arise from their current and potential customers who might also demand the same price that McDonalds will receive. Which could in the long run lose these customers or mean that Devon would have to find improved ways to lower their costs, to be able to sell at this lower price.

They would have to determine how long the McDonald’s Ordering contract would last for, and if the price could be evaluated after each financial year. This would become apparent because costs can change from year to year, and if Devon isn’t able to change their prices to correlate with the added costs, they could be losing significant amounts of money through the McDonalds deal in the future.

. Activity Based Costing

.1 Briefly comment if activity based costing would benefit Devon Quality Dairy?

Activity based costing (ABC) would benefit Devon significantly, because ABC is a cost allocation system that assigns costs to products, services, or customers based upon the consumption of resources caused by activities. While there current costing system is a volume-based costing system, that is only useful when direct labour and materials are the only predetermined factors of production.

In the case of Devon where they have many predetermined factors ABC analysis is far more accurate. With ABC resources are assigned to activities, from which these activities are assigned to cost objects based upon the activities used by the company.

It is because of this we that an activity based costing system would be extremely beneficial for Devon’s analysis of their costs.

. Devon Quality Dairy have asked you to undertake an initial ABC analysis using the following activity breakdown.

Activity Total Costs Cost Driver Cost Driver Cost Rate

Amount

Pasteurisation and Separation 1,111,550 Raw Milk Gallons 60,000,000 $ 0.0185

Bottling Labour 500,000 Gallons of Mix 11,600,000 $ 0.041

Other Mix Department Costs ,007,070 Number of Batches 000 $1,00.550

Delivery Stop Costs 840,000 Number of Stops 84000 $ 10.0000

Other Delivery Costs 1,068,000 Gallons of Mix 11,600,000 $ 0.01

Selling and Administration ,600 Number of Orders 84,000 $ .45

. Prepare a new cost estimate for the McDonald’s order using the activity cost rates.

McDonalds Order using Activity Based Costing

Sales Revenue 1,40,000

less Variable Costs

Direct Cost 1,607,000

Indirect Costs

Factory Overhead

- Pasteurisation and Separation 55,500

- Bottling Labour 4,100

- Other Mix Department 0 8,600

Delivery Costs

- Delivery Stop Costs 46,800

- Other Delivery Costs ,100 18,00

Selling and Administration

- Selling and Admin Costs 16,57 16,57 5,857 1,860,857

Contribution Margin from McDonalds Order using ABC $ 7,14

Calculation

Using batch size as an allocation base.

a One batch can produce 10,000 gallons of mix. So ,000 batches can produce 0,000,000 gallons of mix.

b Devon currently produces 0,000,000 gallons of mix, but only sells 11,600,000 gallons of mix, meaning they will not incur any additional batch costs for the McDonalds Order.

c With the McDonalds Order Devon will need to deliver to 0 restaurants, three times per week.

Sales Revenue = $1.41,000,000

Direct Costs = $1.6071,000,000

Pasteurisation and Separation = $0.0185(60,000,000/0,000,000)1,000,000 a

Bottling Labour Costs = $0.0411,000,000

Other Mix Department Costs = $10,00.550 b

Delivery Costs = $1005c

Other Delivery Costs = $0.011,000,000

Selling and Administration = $.4505 c

.4 Would you accept the McDonald’s order?

After using the activity based costing to calculate the overhead costs in relation to the operations involved with McDonald’s order, we believe that Devon should accept the special order. With the application of ABC, we found that Devon actually incurs less costs than it did before, when it was operating under the traditional costing system. With ABC being a more in-depth system of costing you could be reasonably sure of the costs and would definitely accept the McDonalds Order.

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