Star Brewery – Part 3 – Activity Accounting 

Star Brewery – Part 3 – Activity Accounting 

          STAR Brewery has had a good working experience with you. Recently, you have provided important insights into its budgeting procedures, particularly its cash budgeting projections, and assisted them in understanding how company managers should approach important questions of outsourcing and adding new product lines. Based on the quality of these contributions, you are being approached once again.  STAR has learned about another regional brewery that is rethinking its production model based on a concept called Activity-based Costing. Specifically, managers in this brewery are concerned that the current method being used to allocate overhead to its beer lines may be misrepresenting the profitability/loss of individual product lines and causing them to make inappropriate decisions. Your STAR brewery contact has informed you that the competitor is thinking of switching their current costing system to one called “activity accounting”.  However, no one at STAR knows much about this kind of cost allocation system. They have asked you to investigate this and to determine whether such as system might be appropriate for STAR.

The reality is that your team has only just learned about ABC and you quickly need to bring yourself up to speed before you can make any reasoned recommendations to STAR. However, you don’t have direct access to the competitor’s data or results, materials in text books are too general and surprisingly, you have found that even professionals in accounting service firms can’t assist you much or if they can, will charge you a considerable fee for their advice. Fortunately, you have found an accounting professor who has both written about and worked in this area.  You have come to this individual for advice.  The professor feels strongly that you can only develop a competency in ABC by doing it yourself (one of his favourite expressions is that “accounting is not a spectator sport”).  He has prepared the following case for you and asked you to complete it. Successful completion of this case, he says, will put you in a position to make recommendations to STAR.

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Competitor Brewing Company

Jack Timson, controller of the Competitor Brewing Company, was concerned about the recent financial trends in operating results.  Competitor Brewing had been the low-cost producer of traditional DARK beer and EXTREME DARK beer. Profit margins were once over 20% of sales.

Several years earlier Banvir Harvey, the sales and marketing manager, had seen opportunities to expand the business by extending the product line into new products that offered premium selling prices over traditional DARK and EXTREME DARK beers. Five years earlier CREAM ALE had been introduced, which required the same basic production technology but could be sold at a 3% premium.  And last year LITE beer had been introduced because of the 10% premium in selling price it could command.

But Timson had just seen the financial results (see Exhibit 1) for the most recent fiscal year and was keenly disappointed.

The new CREAM ALE and LITE beers do seem more profitable than our DARK and EXTREME DARK beers, but overall profitability is down and even the new products are not earning the margins we used to see from our traditional products.  Perhaps this is the tougher global competition I have been reading about.  At least the new line, particularly LITE beer, is showing much higher margins.  Perhaps we should follow Banvir’s advice and introduce even more specialty type beers. Banvir claims that consumers are willing to pay higher prices for these specialty brews.

Sparky Douglas, the manufacturing manager, was also reflecting on the changed environment at Competitor Brewing.

Five years ago, life was a lot simpler.  We produced just DARK and EXTREME DARK beers in long production runs, and everything ran smoothly, without much intervention.  Difficulties started when the CREAM ALE was introduced and we had to make more changeovers.  This required us to stop production, empty the vats, clean out all remnants of the previous darker coloured beers, and then start the production of the CREAM ALE beer. Making EXTREME DARK beer was simple; we didn’t even have to clean out the residual from the DARK beer run if we just dumped in enough EXTREME DARK ingredients to cover it up.  But for the CREAM ALE, even small traces of the dark or extreme dark beer leftovers created quality problems.  And the ingredients for the new LITE beer also have demanding specifications, but not quite as demanding as for CREAM ALE beer.

We seem to be spending a lot more time on purchasing and scheduling activities and just keeping track of where we stand on existing, backlogged, and future orders.  The new computer system we got last year helped a lot to reduce the confusion.  But I am concerned about rumours I keep hearing that even more new speciality products may be introduced in the near future.  I don’t think we have any more capability to handle additional confusion and complexity in our operations.

Operations

Competitor Brewing produced beer in a single factory.  The major task was preparing and mixing the ingredients for the different types of beer. The ingredients were inserted into the vats in a semi-automated process.  A final packing and shipping stage was performed manually.

Each beer product had a bill of materials (BOM) that identified the quantity and cost of direct materials required for the product.  A routing sheet identified the sequence of operations required for each operating step.  This information was used to calculate the labour expenses for each of the four products.  All of the plant’s indirect expenses were aggregated at the plant level and allocated to products based on their direct labour content.  Currently this overhead burden rate was 300% of direct labour cost.  Most people in the plant recalled that not too many years ago the overhead rate was only 250%.

Activity-Based Costing

Jack Timson had recently attended a seminar of his professional organization in which a tall grey haired, beer loving, professor had talked about a new concept, called activity-based costing (ABC).  This concept seemed to address many of the problems he had been seeing at Competitor Brewing.  The speaker had even used an example (something weird like “strips”) that seemed to capture a lot of similarities in Competitor Brewing’s situation.

The professor had argued that overhead should not be viewed as a cost or a burden to be allocated on top of direct labour.  Rather, the organization should focus on activities performed by the indirect and support resources of the organization and try to link the cost of performing these activities directly to the products for which they were performed.

Timson obtained several books and articles on the subject and soon tried to put into practice the message he had heard and read about.

Activity-Based Cost Analysis

Timson and his staff first identified six categories of support expenses that were currently being allocated to beer production:

Expense Category                    Expense

Indirect Labour                                    $104,100
Fringe Benefits                         81,000
Computer Systems                     50,000
Machinery                                 36,000
Maintenance                              16,000
Energy                                         8,100
Total                                       $295,200

He determined that the fringe benefits (Canada Pension Plan, etc) were 40% of labour expenses (both direct and indirect) and would thus represent just a percentage mark-up to be applied on top of direct and indirect labour charges.

Timson interviewed department heads in charge of indirect labour and found that three main activities accounted for their work.  About half of indirect labour was involved in scheduling or handling production runs.  This included scheduling production orders, purchasing, preparing, and releasing materials for the production run, first-item inspection performed every time the process was changed over, and some scrap loss at the beginning of each run until the process settled down.  Another 40% of indirect labour was required just for the physical changeover from one type of beer to another.

The time to change over to EXTREME DARK beer was relatively short (about 1 hour) since the previous beer did not have to be completely eliminated from the machinery.  Other beers required longer changeover times; CREAM ALE required the most extensive changeover to meet the demanding quality specification for this type of beer.

The remaining 10% of the time was spent maintaining records on the four products, including the bill of materials and routing information, monitoring and maintaining a minimum supply of raw materials and finished goods inventory for each product, improving the production processes, and performing engineering changes for the products.

Timson also collected information on potential activity cost drivers for Competitor Brewing’s activities (see Exhibit 2) and the distribution of the cost drivers for each of the four products.

Timson next turned his attention to the $50,000 of expenses to operate the company’s computer system.  He interviewed the managers of the Data Centre and the Management Information System departments and found that most of the computer’s time (and software expense) was used to schedule production runs in the factory and to order and pay for the materials required in each production run.

Since each production run was made for a particular customer, the computer time required to prepare shipping documents and to invoice and collect from a customer was also included in this activity.  In total, about 80% of the computer resource was involved in the production run activity.  Almost all of the remaining computer expense (20%) was used to keep records on the four products, including production process and associated engineering change notice information.

The remaining three categories of overhead expense (machine depreciation, machine maintenance, and the energy to operate the machines) were incurred to supply machine capacity to produce the beers.  The machines had a practical capability of 16,000 hours of productive time that could be supplied to beer production.

Timson believed he now had the information to estimate an activity-based cost model for Competitor Brewing.

Exhibit 1 Traditional Income Statement

Exhibit 2 Direct Costs and Activity Cost Drivers

Required: (This assignment should be done in teams of two. You decide)

1. Using the information provided in the case, use your knowledge of activity-based costing to develop a resource driver worksheet, an activity driver worksheet and a revised product line income statement (a sample resource driver sheet is shown below).
2. In an executive memo to Jack Timson, provide an analysis of what you have observed about Competitor Brewing’s operations and, if applicable, provide some ideas/solutions to what Competitor Brewing could do to improve its results.
3. Based on what you and your team have learned from this exercise, write a report (maximum 3 pages) to STAR Brewery that outline your recommendations as to whether you feel that Activity-based Costing and/or Activity-based Management would be worthwhile adopting in STAR Brewery. Provide a rationale for your answer.