Question: Traditional Versus ABC Systems Northwest Desserts, Inc., (NDI) produces a variety of premium cheesecakes and sells them in individual packages directly to retail customers and in packages of 10 cakes to restaurants in Washington, Oregon, Idaho, and Northern California. NDI started as a small retail outlet, where it developed a superb reputation for quality. In the late 1990s it opened a chain of retail outlets. Only recently it started selling cheesecakes to restaurants. Its penetration into the restaurant market has been slower than predicted. Although NDI produces several types of cheesecakes, all are about the same size and are considered a single product for costing purposes. NDI's existing costing system has a single direct-cost category-ingredients-and a single indirect-cost pool-production overhead. The system does not trace labor costs to the products; it considers them part of production overhead. Production overhead is allocated on the basis of number of cheesecakes produced. The 2013 budget projected production of 500,000 cheesecakes, 400,000 for the retail market and 100,000 for restaurants. Predicted costs were as follows:
In early 2012 NDI had unsuccessfully bid for a large restaurant contract from the Applebee's chain. Its bid had been 30% above that of the successful bidder. This came as a shock because NDI had budgeted only a small profi t into the bid. In addition, the NDI plant was one of the newest and most efficient in the industry. Before completing the budget for 2013, top management of NDI asked Naomi Lester, controller of NDI, to examine the company's cost accounting system. Naomi had attended a short course by the Institute of Management Accountants on activity-based costing (ABC), and she thought some of the principles of ABC might apply to NDI. She felt that accounting for the ingredients was not a problem; the ingredients cost the same whether a cheesecake was produced for retail or restaurant markets. However, when she analyzed production overhead costs, she saw several possible improvements. Naomi found that production overhead costs could be divided into cost pools for four activities:
1) administration,
2) facilities operations and maintenance,
3) mixing/baking, and
4) decorating/ packaging.
The activities in administration and facilities operations and maintenance do not involve working directly on cheesecakes, but they support the areas in which the cheese-cakes are produced. Mixing/baking and decorating/packaging are the activities that directly produce the cheesecakes. Naomi described the four activities as follows:
Facilities Operations and Maintenance: Two employees, located in an 800 sq. ft. office wing, operate and maintain the facilities. In addition, rent and depreciation charges and the cost of supplies for operating and maintaining the facilities are included in this cost pool. These facilities operations and maintenance costs are closely related to the number of square feet of space used. Budgeted facilities operations and maintenance costs are $320,000.
Mixing and Baking: Five employees are located in 4,000 sq. ft. of space with a capacity to produce 600,000 cheesecakes per year. Much of the mixing and baking operation is the same for all cheesecakes produced. However, the cheesecakes sold through NDI's own retail outlets require some special handling to give them a distinctive quality. The production line produces 80 retail cheesecakes per processing hour and 100 restaurant cheesecakes per processing hour. Costs are driven by the number of processing hours. Budged costs in mixing and baking are $540,000.
Decorating and Packaging: Decorating and packaging require two employees and 1,000 sq. ft. of space. There are two separate decorating/packaging lines. Only 10 retail cheesecakes can be decorated and packaged per hour, while 50 restaurant cheesecakes can be decorated and packaged in the same amount of time. Costs vary with the number of decorating/packaging hours. Budgeted costs are $1,216,000. Of this total cost, $376,000 is for packaging materials that could be traced to individual products, $360,000 to retail, and $16,000 to restaurants sales.
1. Use the existing costing system to find the budgeted cost per cheesecake for
(a) the retail market and
(b) the restaurant market. Comment briefly on the weaknesses of this system.
2. Use the ABC system to find the budgeted cost per cheesecake for
(a) the retail market and
(b) the restaurant market.
3. Prepare a memo from Naomi Lester to the president of NDI commenting on the differences in the costs between the traditional and ABC systems. Why are they different? What decisions should be made differently now that NDI has the information from the ABC system rather the information from the traditional system? How should managers use the ABC information to make better decisions?