ABC, activity area cost-driver rates, product cross-subsidization Idaho Potatoes (IP) operates at capacity and processes potatoes into potato cuts at its highly automated Pocatello plant. It sells potatoes to the retail consumer market and to the institutional market, which includes hospitals, cafeterias, and university dormitories.
IP’s simple costing system has a single direct-cost category (direct materials, which are the raw potatoes) and a single indirect-cost pool (production support). Support costs are allocated on the basis of pounds of potato cuts processed. Support costs include packaging materials. The 2009 total actual costs for producing 1,000,000 pounds of potato cuts (900,000 for the retail market and 100,000 for the institutional market) are:
Direct materials used $150,000
Production support $983,000
The simple costing system does not distinguish between potato cuts produced for the retail and the institutional markets.
At the end of 2009, IP unsuccessfully bid for a large institutional contract Its bid was reported to be 30% above the winning bid. This feedback came as a shock because IP included only a minimum profit margin on its bid. Moreover, the Pocatello plant was acknowledged as the most efficient in the industry.
As a result of its review process of the lost contract bid, IP decided to explore ways to refine its costing system. First it identified that $188,000 of the $983,000 pertaining to packaging materials could be traced to individual jobs ($180,000 for retail and $8,000 for institutional). These costs will now be classified as direct materials. The $150,000 of direct materials used were classified as $135,000 for retail and $15,000 for institutional. Second, it used ABC to examine how the two products (retail potato cuts and institutional potato cuts) used indirect support resources. The finding was that three activity areas could be distinguished.
Cleaning Activity Area—IP uses 1,200,000 pounds of raw potatoes to yield 1,000,000 pounds of potato cuts. The cost-allocation base is pounds of raw potatoes cleaned. Costs in the cleaning activity area are $120,000.
Cutting Activity Area—IP processes raw potatoes for the retail market independently of those processed for the institutional market. The production line produces (a) 250 pounds of retail potato cuts per cutting-hour and (b) 400 pounds of institutional potato cuts per cuffing-hour. The cost allocation base is cuffing-hours on the production line. Costs in the cutting activity area are $231,000. Packaging Activity Area—IP packages potato cuts for the retail market independently of those packaged for the institutional market. The packaging line packages (a) 25 pounds of retail potato cuts per packaging-hour and (b) 100 pounds of institutional potato cuts per packaging-hour. The cost-allocation base is packaging-hours on the production line. Costs in the packaging activity area are $444,000.
1. Using the simple costing system, what is the cost per pound of potato cuts produced by IP?
2. Calculate the cost rate per unit of the cost driver in the (a) cleaning, (b) cutting, and (c) packaging activity areas.
3. Suppose IP uses information from its activity cost rates to calculate costs incurred on retail potato cuts and institutional potato cuts. Using the ABC system, what is the cost per pound of (a) retail potato cuts and (b) institutional potato cuts?
4. Comment on the cost differences between the two costing systems in 1 and 3. How might IP use the information in 3 to make better decisions?