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CASE 4-2

SOFT DRINK AND BEER

AÑORA, TESYL MAE BSA-4

CENTINO. ROWEL BSA-4

Table of Contents

CHAPTER 1 3

CASE ABSTRACT 3

MANAGEMENT’S DILEMMA 3

MANAGEMENT QUESTION 3

RESEARCH QUESTIONS: 3

CHAPTER 2 4

Part 1 – Understanding the Industry 4

Part 2 – Understanding the Nature of the Entity 5

CHAPTER 3 11

REFERENCES: 24

CASE BRIEF

CHAPTER 1

CASE ABSTRACT

Mr. Carlito Buenafe, Phoenix Marketing Corporation’s owner, was assessing the profitability of its franchise contract for soft drinks to determine whether or not new terms of the contract will be renegotiated or to entirely beg off from renewing the contract. So far, he has initial profitability assessment for the two contracts but it was still incomplete since he has not yet considered allocating another major expense item which is the warehouse cost. Initially, he thought of allocating the warehouse cost by using the relative proportion of the commissions from both products. However, he remembered the concept of cost drivers he learned from college. He still needs to consider the appropriate base to be used in allocating each component of the warehouse cost and also take into consideration that the contract for soft drink commenced only in July 2001 in order to arrive at the correct assessment.

MANAGEMENT’S DILEMMA

The dilemma that Mr. Carlito Buenafe is facing is whether or not to renegotiate new terms of the contact for the soft drink distribution at the start of year 2002 or to entirely beg off from renewing it.

MANAGEMENT QUESTION

How can the management be able to allocate the components of warehouse cost using appropriate activity drivers in assessing properly the profitability of each contract in order to come up a decision whether to renew the contract or not?

RESEARCH QUESTIONS:

1. Why should cost be allocated properly?

2. What are the building block concepts of a costing system?

3. What are the costing systems that PMC could apply?

4. What is the appropriate costing system Mr. Buenafe should apply?

5. What will be the decision of Mr. Buenafe regarding the soft drink contract after using the appropriate costing system?

6. What is the effect of the time period covered by the softdrink contract to the allocation?

CHAPTER 2

Part 1 – Understanding the Industry

SOFTDRINK INDUSTRY

Defining the Industry:

The Soft Drink Industry consists of establishments primarily engaged in manufacturing non-alcoholic, carbonated beverages, mineral waters and concentrates and syrups for the manufacture of carbonated beverages. This industry would include concentrate producers and bottlers. These two parts of the industry are extremely interdependent, sharing costs in procurement, production, marketing and distribution. Many of their functions overlap; for instance, concentrate producers do some bottling, and bottlers conduct many promotional

activities. The industry is already vertically integrated to some extent. They also deal with similar suppliers and buyers. Entry into the industry would involve developing operations in either or both disciplines. Beverage substitutes would threaten both CPs and their associated bottlers. This industry as a whole generates positive economic profits.

Rivalry:

Revenues are extremely concentrated in this industry, with Coke and Pepsi, together with their associated bottlers. In fact, one could characterize the soft drink market as an

oligopoly, or even a duopoly between Coke and Pepsi, resulting in positive economic profits. To be sure, there was tough competition between Coke and Pepsi for market share, and this occasionally hampered profitability.

Substitutes:

Through the early 1960s, soft drinks were synonymous with “colas” in the mind of consumers. Over time, however, other beverages, from bottled water to teas, became more popular, especially in the 1980s and 1990s. Coke and Pepsi responded by expanding their offerings, through alliances (e.g. Coke and Nestea), acquisitions (e.g. Coke and Minute Maid), and internal product innovation (e.g. Pepsi creating Orange Slice), capturing the value of increasingly popular substitutes internally. Overall, because of the concentrate producers’ efforts in diversification, substitutes became less of a threat.

Power of Suppliers:

The inputs for Coke and Pepsi’s products were primarily sugar and packaging. Sugar could be purchased from many sources on the open market, and if sugar became too expensive, the firms could easily switch to corn syrup, as they did in the early 1980s. So suppliers of nutritive sweeteners did not have much bargaining power against Coke, Pepsi, or their bottlers. With an abundant supply of inexpensive aluminum in the early 1990s and several can companies competing for contracts with bottlers, can suppliers had very little supplier power. Furthermore, Coke and Pepsi effectively further reduced the supplier of can makers by negotiating on behalf of their bottlers, thereby reducing the number of major contracts available to two. With more than two companies vying for these contracts, Coke and Pepsi were able to negotiate extremely favorable agreements. In the plastic bottle

business, again there were more suppliers than major contracts, so direct negotiation by the concentrate producers was again effective at reducing supplier power.

Buyers:

The soft drink industry sold to consumers through five principal channels: food stores,

convenience and gas, fountain, vending, and mass merchandisers.

Barriers to Entry:

It would be nearly impossible for either a new concentrate producer(CP) or a new bottler to enter the industry. New CPs would need to overcome the tremendous marketing muscle and market presence of Coke, Pepsi, and a few others, who had established brand names that were as much as a century old. These companies had intimate relationships with their retail channels and would be able to defend their positions effectively through discounting or other tactics. So, although the CP industry is not very capital intensive, other barriers would prevent entry. Entering bottling, meanwhile, would require substantial capital investment, which would deter entry. Further complicating entry into this market, existing bottlers had

exclusive territories in which to distribute their products.

Employment Opportunities:

The top five occupations in this industry are:

* Process control and machine operators, food and beverage processing;

* Truck drivers;

* Sales representatives, wholesale trade;

* Delivery drivers; and

* Material handlers.

Criticisms:

There has been a lot of controversy whether soft drinks are a health hazard or not. The consumption of sugar-sweetened soft drinks is associated with obesity, type 2 diabetes, dental cavities, and low nutrient levels.

Part 2 – Understanding the Nature of the Entity

Coca-cola Bottlers Corporation, Inc.

• Business Operations

Products

The Coca-Cola Company is the world’s leading owner and marketer of nonalcoholic beverage brands and the world’s largest manufacturer, distributor and marketer of concentrates and syrups used to produce nonalcoholic beverages. They own or license and market more than 500 non-alcoholic beverage brands, primarily sparkling beverages but also a variety of still beverages such as waters, enhanced waters, juices and juice drinks, ready-to-drink teas and coffees, and energy and sports drinks.

Their Trademark Coca-Cola Beverages include Coca-Cola, caffeine free Coca-Cola, Cherry Coke, Diet Coke (sold as Coca-Cola Light in many countries other than the United States), caffeine free Diet Coke, Diet Coke Sweetened with Splenda, Diet Coke with Lime, Diet Cherry Coke, Coca-Cola Zero (sold as Coke Zero in some countries), Fanta, Sprite, Diet Sprite/Sprite Zero (sold as Sprite Light in many countries other than the United States).

Their beverage products also include enhanced water products such as vitamin water and smart water.

Production

Coca-Cola beverage products begin as raw material and go through many stages, until the final step when the finished products reach the consumer.

1. The first step in creating "Coca-Cola" is quite simple: to make a syrup of sugar and water. The water is carefully purified because for "Coca-Cola" absolutely top quality ingredients are required.

2. To be certain that the water used for bottling and canning is clean and pure, local drinking water is filtered and purified. Quality control technicians test the water frequently as it is used to make the finished product.

3. The checking and testing continues. Sophisticated equipment helps technicians check everything from the condition of each package to details of the carbonation level, taste and syrup content. Here the syrup mix is checked.

4. "Coca-Cola" concentrate is added to the syrup. This flavor base for "Coca-Cola Company manufacturing plants and still remains one of the world's great trade secrets. Technicians carefully sample, check and record the blend of each batch of syrup. After blending, it is ready to have the 'bubbles' or carbonation, added. Strict quality control is the reason "Coca-Cola" is famous for a perfect level of 'bubbliness'.

5. An army of glass and PET (Polyethylene terephthalate) bottles, as well as cans, is now ready to be filled with the finished product. The bottles go through a throughout test: first they're washed, rinsed and inspected electronically and visually Only then are they ready to be filled with the world's most popular soft drink.

6. The conveyor lines up bottle after bottle to be filled automatically. This way the amount in each is exact, and the automatic sealing of each bottle guarantees complete hygiene.

7. At last the bottles are labeled, date coded and packed into cartons. The sales centre is then ready to dispatch "Coca-Cola" to the more than 420,000 outlets in Indonesia which stock "Coca-Cola" product.

Marketing Activities

a. Strategic Priorities

Coca-Cola have four strategic priorities designed to create long-term sustainable growth for their Company and the Coca-Cola system and value for their shareowners. These strategic priorities are driving global beverage leadership; accelerating innovation; leveraging their balanced geographic portfolio; and leading the Coca-Cola system for growth. To enable the entire Coca-Cola system to deliver on these strategic priorities, they must further enhance their core capabilities of consumer marketing; commercial leadership; and franchise leadership.

b. Consumer Marketing

Marketing investments are designed to enhance consumer awareness of and increase consumer preference for Coca-Cola brands. This produces long-term growth in unit case volume, per capita consumption and their share of worldwide non-alcoholic beverage sales. Through their relationships with bottling partners and those who sell their products in the marketplace, they create and implement integrated marketing programs, both globally and locally, that are designed to heighten consumer awareness of and product appeal for their brands. In developing a strategy for a Company brand, they conduct product and packaging research, establish brand positioning, develop precise consumer communications and solicit consumer feedback.

Their integrated marketing activities include, but are not limited to, advertising, point-of-sale merchandising and sales promotions. The company have disciplined marketing strategies that focus on driving volume in emerging markets, increasing their brand value in developing markets and growing profit in most developed markets. In emerging markets, they are investing in infrastructure programs that drive volume through increased access to consumers. In developing markets, where consumer access has largely been established, their focus is on differentiating their brands. They continue to invest in brands and infrastructure programs, but at a slower rate than revenue growth. They are focused on affordability and ensuring they are communicating the appropriate message based on the current economic environment.

c. Marketing Expenditures

Coca-Cola company makes significant marketing expenditures in support of their brands, including expenditures for advertising, sponsorship fees and special promotional events. As part of their marketing activities, they provide retailers and distributors with promotions and point-of-sale displays; their bottling partners with advertising support and funds designated for the purchase of cold-drink equipment; and their consumers with coupons, discounts and promotional incentives. These marketing expenditures help to enhance awareness of and increase consumer preference for their brands. They believe that greater awareness and preference promote long-term growth in unit case volume, per capita consumption and their share of worldwide non-alcoholic beverage sales.

Conduct of Operations

The Coca‑Cola System

Coca-Cola Company is a global business that operates on a local scale in every community where they do business. They create global reach with local focus because of the strength of the Coca‑Cola system, which comprises their Company and their bottling partners—more than 300 worldwide. The Company manufactures and sells concentrates, beverage bases and syrups to bottling operations; owns the brands; and is responsible for consumer brand marketing initiatives. Their bottling partners manufacture, package, merchandise and distribute the finished branded beverages to their customers and vending partners, who then sell their products to consumers.

All bottling partners work closely with customers—grocery stores, restaurants, street vendors, convenience stores, movie theaters and amusement parks, among many others—to execute localized strategies developed in partnership with their Company. Customers then sell their products to consumers at a rate of 1.6 billion servings a day.

Their business operations are divided into the following geographies: Eurasia and Africa, Europe, Latin America, North America and Pacific, as well as our Bottling Investments Group.

Alliances, Joint Ventures and Outsourcing Activitites

Bottler’s Agreements and Distribution Agreements

Most of Coca-Cola products are manufactured and sold by their bottling partners. They typically sell concentrates and syrups to their bottling partners, who convert them into finished packaged products which they sell to distributors and other customers. Separate contracts (‘‘Bottler’s Agreements’’) exist between Coca-Cola Company and each of their bottling partners

regarding the manufacture and sale of Company products. Subject to specified terms and conditions, the Bottler’s Agreements generally authorize the bottlers to prepare specified Company Trademark Beverages, to package the same in authorized containers, and to distribute and sell the same in an identified territory.

They typically agree to refrain from selling or distributing, or from authorizing third parties to sell or distribute, the designated Company Trademark Beverages throughout the identified territory in the particular authorized containers; however, they typically reserve for themselves or their designee the right (1) to prepare and package such beverages in such containers in the territory for sale outside the territory, and (2) to prepare, package, distribute and sell such beverages in the territory in any other manner or form. Being a bottler does not create a legal partnership or joint venture between them and their bottlers. Their bottlers are

independent contractors and are not their agents.

The Bottler’s Agreements between the Cola-Cola Company and their authorized bottlers are of stated duration, subject in some cases to possible extensions or renewals of the term of the contract.

• Investments and Investment Activities

Coca-Cola Company maintains business relationships with three types of bottlers:

• bottlers in which the Company has no ownership interest;

• bottlers in which the Company has invested and has a non-controlling ownership interest; and

• bottlers in which the Company has invested and has a controlling ownership interest.

They make equity investments in selected bottling operations with the intention of maximizing the strength and efficiency of the Coca-Cola system’s production, distribution and marketing capabilities around the world. These investments are

intended to result in increases in unit case volume, net revenues and profits at the bottler level, which in turn generate increased concentrate sales for our Company’s concentrate and syrup business. When this occurs, both the company and their bottling partners benefit from long-term growth in volume, improved cash flows and increased shareowner value.

The level of their investment generally depends on the bottler’s capital structure and its available resources at the time of the investment.

• Financing and financing activities

a. Debt Financing

Coca-Cola Company maintains debt levels they consider prudent based on their cash flows, interest coverage ratio and percentage of debt to capital. They use debt financing to lower their overall cost of capital, which increases their return on shareowners’ equity. This exposes them to adverse changes in interest rates. Their interest expense may also be affected by their credit ratings.

Coca-Cola’s global presence and strong capital position give them access to key financial markets around the world, enabling them to raise funds at a low effective cost. This posture, coupled with active management of their mix of short-term and long-term debt and their mix of fixed-rate and variable-rate debt, results in a lower overall cost of borrowing.

b. Issuances of Stock

The issuances of stock in the years 2009, 2008 and 2007 are primarily related to the exercise of stock options by Company employees.

• Financial reporting

INDUSTRY FACTORS

Market and Competitive Environment

Coca-Cola Company competes in the non-alcoholic beverages segment of the commercial beverages industry. The non-alcoholic beverages segment of the commercial beverages industry is highly competitive, consisting of numerous firms. These firms compete in multiple geographic areas, as well as firms that are primarily regional or local in operation. Competitive products include numerous non-alcoholic sparkling beverages; various water products, including packaged, flavored and enhanced waters; juices and nectars; fruit drinks and dilutables (including syrups and powdered drinks); coffees and teas; energy and sports and other performance-enhancing drinks; dairy-based drinks; functional beverages; and various other non-alcoholic beverages. These competitive beverages are sold to consumers in

both ready-to-drink and other than ready-to-drink form. In many of the countries in which the company do business PepsiCo, Inc., is one of their primary competitors.

In certain markets, competition includes beer companies. They also compete against numerous regional and local firms and, in some markets, against retailers that have developed their own store or private label beverage brands.

Competitive factors impacting their business include, but are not limited to, pricing, advertising, sales promotion programs, product innovation, increased efficiency in production techniques, new vending and dispensing equipment, and brand and trademark development and protection. Their competitive strengths include leading brands with a high level of consumer acceptance; a worldwide network of bottlers and distributors of Company products.

Consumer demand determines the optimal menu of Company product offerings. Consumer demand can vary from one locale to another and can change over time within a single locale. Employing their business strategy, and with special focus on core brands, their Company seeks to build its existing brands and, at the same time, to broaden its historical family of brands, products and services in order to create and satisfy consumer demand locale by locale.

Cyclical or Seasonal Activity

Sales of Coca-Cola ready-to-drink non-alcoholic beverages are somewhat seasonal, with the second and third calendar quarters accounting for the highest sales volumes. The volume of sales in the beverages business may be affected by weather conditions.

REGULATORY FACTORS

Governmental Regulation

Coca-Cola Company is required to comply, with applicable laws in the numerous countries throughout the world in which they do business. In many jurisdictions, compliance with competition laws is of special importance to them.

The production, distribution and sale of Company’s products are subject to the local workplace health and safety laws; various local environmental protection laws; and various other local statutes and regulations applicable to the production, transportation, sale, safety, advertising, labeling and ingredients of such products. The distribution and sale of their many products and related operations are also subject to numerous similar and other statutes and regulations.

OTHER FACTORS

Coca-Cola Company, along with other beverage companies, are affected by a number of factors, including, but not limited to, cost to manufacture and distribute products, consumer spending, economic conditions, availability and quality of water, consumer preferences, inflation, political climate, local and national laws and regulations, foreign currency exchange fluctuations, fuel prices and weather patterns.

a. Impact of Inflation and Changing Prices

Inflation affects the way Coca-Cola Company operates in many markets around the world. In general, they believe that, over time, they are able to increase prices to counteract the majority of the inflationary effects of increasing costs and to generate sufficient cash flows to maintain their productive capability.

b. Foreign Exchange

Coca-Cola’s international operations are subject to certain opportunities and risks, including currency fluctuations and governmental actions. They closely monitor their operations in each country and seek to adopt appropriate strategies that are responsive to changing economic and political environments, and to fluctuations in foreign currencies.

They use 72 functional currencies. Due to their global operations, weakness in some of these currencies might be offset by strength in others.

CHAPTER 3

1. Why should cost be allocated properly?

Management needs prompt cost information in the decision making process. In any type of organization, it is imperative for management to be aware not only of its total cost and expenses, but also of the specific product or activity for which, cost per unit and per work unit of its product and services, respectively, and of whether the amounts incurred are in accordance with financial plans and standards.

Cost Assignment is a general term for assigning costs, whether direct or indirect, to a cost object. Cost Tracing is a specific term for assigning direct cost. Cost Allocation refers to assigning indirect costs.

The way costs are assigned depends on the costing system employed by the system. Costing system aims to report cost numbers that reflect the way chosen cost objects use the resources. Cost System is one wherein flow of costs is accounted for in detail so that unit costs and inventory costs can be promptly determined.

An effective cost system ensures that the company benefits from all its expenditures, that is, cost incurred contribute to the production of the desired quantity of goods and services.

2. What are the building block concepts of a costing system?

The building block concepts of a costing system are cost objects, direct cost of a cost object, indirect cost of a cost object, cost pool and cost-allocation base.

a. A cost object is anything for which a separate measurement of cost is needed. In this case there are two cost objects and these are the two products that PMC distributes. These are the beer and the soft drinks.

b. Direct costs are costs that can be traced directly to the cost object in an economically feasible way. In this case, the direct costs traceable to the cost objects are the delivery charges and cargo charges.

c. Indirect Costs are related to the cost objects but these costs cannot be traced to the two products in an economically feasible way. These costs are partly variable and partly fixed. For practical reasons, these costs are lumped together.

The indirect costs incurred by PMC are the warehouse costs. The components of the warehouse costs are warehouse rent, salary of dispatcher, salaries of checker, and salaries of warehousemen, salaries of administrative staff, utilities, and security services.

d. Cost Pools are groupings of individual cost items. Cost Pools are organized in conjunction with cost-allocation bases.

e. Cost Allocation Base links in a systematic way an indirect cost to a cost object. In this case, we use cost driver of indirect cost as the allocation base because of the cause-and-effect link between changes in the level of the cost driver and changes in indirect cost.

*These concepts will be used to decide the costing system for an organization.

3. What are the costing systems that PMC could apply?

The basic purpose of any costing system is to allocate the cost to the units.

a. Mr. Buenafe could use the Simple/Traditional costing system that prevailed before the rise of activity-based costing in the 1990s. Geared toward compliance with financial reporting requirements, traditional cost-accounting systems often allocate costs based on single-volume measures such as direct-labor hours, direct-labor costs, or machine hours. The overhead rate in a traditional costing system would typically be calculated using direct labor hours, machine hours, or units. This could lead to accurate product costs when direct costs were high and indirect costs were low, as was usually the case 50 years ago; however, modern organizations typically have low direct costs and higher indirect costs.

The strengths of traditional costing systems are:

a. • simplicity – the calculation of overhead rates is relatively straightforward;

b. • they are widely understood in the business;

c. • they are not expensive to operate;

d. • until the late 1980s they were seen as fairly accurate;

e. • they are still being used after many decades.

The weaknesses of traditional costing systems are:

a. • their reliance on arbitrary rather than cause-and-effect allocation of overheads;

b. • their inability to give accurate product costs.

c. • their failure to analyse indirect costs.

If Mr. Buenafe uses the Simple Costing System using a single indirect cost-pool and using single allocation base which is the sales commission, the following steps will be followed:

Step 1: Identify the products that are chosen cost objects.

The cost objects are beer and softdrinks.

Step 2: Identify the direct cost of the products.

PMC’s direct costs are:

• Delivery charges

• Cargo Charges

Computation of Delivery Charges:

BEER SOFT DRINKS

Number of dispatches 1,183 637

Multiply by: Variable Cost per dispatch 875 875

Total Charge 1,035,125.00 557, 375.00

Computation of Cargo Charges:

BEER SOFT DRINKS

Number of Trips 465 184

Multiply by: Charge per Trip 2,750 2,750

Total Charge 1,278,750.00 506,000.00

Step 3: Select the cost-allocation bases to use for allocating indirect costs to the products.

The relative proportion of the commissions from both products will be used as the allocation basis of the warehouse costs.

Step 4: Identify the indirect costs associated with each cost-allocation base.

All the indirect costs will be lumped in a single cost pool and allocated using the relative proportion of the two products with their respective sales commission.

|Particulars |Amount |

|Warehouse Rent | PhP 350,000.00 |

|Salary of Dispatcher | 78,000.00 |

|Salaries of Checker | 145,000.00 |

|Salaries of Warehousemen | 160,000.00 |

|Salaries of Administrative Staff | 112,540.00 |

|Utilities | 90,000.00 |

|Security Services | 110,600.00 |

|TOTAL |1,046,140.00 |

Step 5: Compute the rate per unit of each cost-allocation base used to allocate indirect cost to the products.

| |Sales Commission |Rate |Allocation | |

| Beer |3,098,868.5 |69.0923957 % |722,803.19 | |

| Soft drink |1,386,239.4 |30.9076042 % |323,336.88 | |

| |4,485,107.9 | |1,046,140.07 | |

Step 6: Compute the indirect cost allocated to each product.

The resulting profitability of the two contracts using this costing system will be the following:

| | | | Beer | Soft drinks |

| Sales Commission | | | 3,098,868.50 | 1,386,239.40 |

| Less: Cargo Charges | 1,278,750.00 | 506,000.00 | | |

| Variable Delivery Costs | 1,035,125.00 | 557,375.00 | | |

| | | | 2,313,875.00 | 1,063,375.00 |

| Partial Operating Margin | | | 784,993.50 | 322,864.40 |

| Less: Warehouse Cost | (Step 5) | | 722,803.19 | 323,336.88 |

| Net Profit/Loss | | | 62,190.31| |

| | | | |(472.48) |

As a result of the computation using traditional costing sysytem, the beer contract resulted to a net profit of P 62, 190.31 while the soft drink contract has a net loss of P 472.48.

b. Mr. Buenafe could use the Activity-Based Costing System.

One development in the area of costing has been in improving cost measurements. An innovation towards determining more accurate costing is called Activity-Based Costing or simply ABC. Activity-Based Costing (ABC) arose in the 1980s from the increasing lack of relevance of traditional cost accounting methods. The traditional cost accounting methods were designed around 1870 - 1920 and in those days industry was labor intensive, there was no automation, the product variety was small and the overhead costs in companies were generally very low compared to today. However, from the 1960s - particularly 1980s - this changed rapidly. For these reasons, and more, traditional cost accounting has been called everything from 'number 1 enemy of production' and questions whether it is 'an asset or a liability' have been raised. ABC costing is a relatively new in the field of accounting, but its practical implementation of the concepts in the field of strategic planning has been known for so many years. This method provides a procedure for a refined allocation of indirect costs. ABC system is one of the best tools for refining a costing system. It calculates the cost of individual activities and assigns cost to cost objects on the basis of the activities needed to distribute the products. Its objective is to trace overheads to product costs as accurately as possible.

ABC has been called one of the most important management innovations the last hundred years. So what is really the difference between ABC and traditional cost accounting methods? Despite the enormous difference in performance, there are three major differences:

1. In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.

2. Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels.

3. Traditional cost accounting is structure-oriented whereas ABC is process-oriented.

But first, the direction of the arrows are different because ABC brings detailed information from the processes up to assess costs and manage capacity on many levels whereas traditional cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost objects without considering any 'cause and effect' relations.

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Direct cost can be traced to products easily, so the ABC system focuses on refining the assignment of indirect cost which is the warehouse cost in this case to the two cost objects, the beer and soft drinks.

When an allocation basis is also the same factor that caused the costs to be incurred, such allocation basis is called a “cost driver”.

The “activity-based” aspect dwells on the fact that resources are consumed by “activities”. As a first allocation process, costs are allocated to these activities, creating Activity Cost Pools. These activity cost pools are subsequently allocated to the cost objects that used or were benefited by the activities, using appropriate bases for allocation.

B1. What are the steps in ABC?

Step 1: Identify the products that are the chosen cost objects.

The cost objects are beer and soft drinks.

Step 2: Identify the direct cost of the products.

PMC’s direct costs are:

• Delivery charges

• Cargo Charges

Computation of Delivery Charges:

BEER SOFT DRINKS

Number of dispatches 1,183 637

Multiply by: Variable Cost per dispatch 875 875

Total Charge 1,035,125.00 557, 375.00

Computation of Cargo Charges:

BEER SOFT DRINKS

Number of Trips 465 184

Multiply by: Charge per Trip 2,750 2,750

Total Charge 1,278,750.00 506,000.00

There is no problem with the direct cost because it can be easily traced to the two products. The problem lies with the indirect cost.

Step 3: Select the cost allocation bases to use for allocating indirect cost to the two products.

The cost drivers that could be used in this cost allocation are the:

• Floor area - PMC's warehouse has a total floor area of 1,500 square meters.

• Number of dispatches

Computation for the Number of Dispatches:

Number of Trucks 7

Multiplied by the number of dispatches per week 5

Multiplied by the number of weeks 52

Total 1,820

Identifying the cost-allocation bases defines the number of activity cost pools into which costs must be grouped in an ABC system. Since the cost drivers identified are two, the cost pools will also be two.

Step 4: Identify the indirect costs associated with each cost-allocation base.

Components of the Warehouse Costs:

• Warehouse Rent

Since the lease contract for warehouse space was based on the area of the warehouse, the appropriate cost driver for warehouse rent is the floor area (square meters of space occupied).

• Salary of dispatcher, checker and warehousemen

The workload of the dispatchers, warehousemen, and checkers occurs every time a dispatch or a delivery is made. Thus, the appropriate cost drivers for the salary of dispatcher, checker and warehousemen is the number of dispatches made.

• Salaries of Administrative Staff

The more product groups that PMC distribute, the number of the invoices and record documents that the administrative staff process correspondingly increases. Thus, the appropriate cost driver for the salaries of administrative staff is the number of dispatches made.

• Utilities

There exist a strong relationship between the incurrence of utility costs and the number of deliveries and dispatches. Thus, the appropriate cost driver for utilities is the number of dispatches made.

• Security Services

Cost for security were fixed regardless of the number of products distributed by PMC. The same allocation bases for warehouse shall be used for this cost which is the floor area (square meters of space occupied).

Thus, warehouse rent and security services can be lumped in one cost pool because they have the same cost driver. While the salaries of dispatcher, checker, warehousemen, administrative staff and the utilities cost can be lumped in one cost pool.

Fixed Activity Costs:

Warehouse Rent P 350,000.00

Security Services 110,600.00

TOTAL 460,600.00

Variable Activity Costs:

Salaries of Dispatcher P 78,000.00

Salaries of Checker 145,000.00

Salaries of Warehousemen 160,000.00

Salaries of Administrative Staff 112,540.00

Utilities 90,000.00

TOTAL 585,540.00

Step 5: Compute the rate per unit of each cost-allocation base used to allocate indirect cost to the products.

Overhead Rates:

Fixed Cost ( PhP 460,600/ 1,500 m2 = 307.0666667/ m2)

Variable Costs ( PhP 585,540/ 1820 dispatches = 321.7252747/ dispatch

Step 6: Compute the indirect costs allocated to the products.

ANNUAL ALLOCATION:

| |BEER |SOFT DRINKS |

|Fixed Costs | | |

|[(1,500 m2 x 60% ) x 307.07/ m2] | | |

|[(1,500 m2 x 40% ) x 307.07/ m2] | | |

|Variable Costs | | |

|( 1,183 dispatches x 321.74/ dispatch) | | |

|( 637 dispatches x 321.74/ dispatch) | | |

|TOTAL | | |

| | | |

| |276,360.00 | |

| | |184,240.00 |

| | | |

| |380,601.00 | |

| | |204,939.00 |

| |656,961.00 |389,179.00 |

Since the soft drink contract commenced in July 2001, any allocation scheme that results in annual figures should allocate only ½ of the amount to soft drinks and “reallocate back” the other ½ to beer.

Computation:

Cost allocated to soft drinks: 389,179.00 x 6/12 = PhP 194,589.50

Cost allocated to beer: 656, 961 + 194,589.5 = PhP 851, 550.50

The resulting profitability of the two contracts using the ABC system will be:

| | | | Beer | Soft drinks |

| Sales Commission | | | 3,098,868.50 | 1,386,239.40 |

| Less: Cargo Charges | 1,278,750.00 | 506,000.00 | | |

| Variable Delivery Costs | 1,035,125.00 | 557,375.00 | | |

| | | | 2,313,875.00 | 1,063,375.00 |

| Partial Operating Margin | | | 784,993.50 | 322,864.40 |

| Less: Warehouse Cost |(Step 6) | | 851, 550.50 | 194,589.50 |

| Net Profit/Loss | | | (66,557.00) | |

| | | | |128, 274.90 |

As a result of the computation using the Activity-Based Costing method, the beer contract resulted to a net loss of P 66,557.00 while the soft drink contract resulted a net profit of P 128,274.90.

*Another way of computing the detailed overhead rate per component of warehouse cost is:

Computation for Overhead Rates:

Warehouse Rent (350,000/1,500 m2 = 233.33/ m2)

Security Services (110,600/1,500 m2 = 73.73/ m2)

Salaries of Dispatcher (78,000/1,820 dispatches = 42.86/dispatch)

Salaries of Checker (145,000/1,820 dispatches = 79.67/dispatch)

Salaries of Warehousemen (160,000/1,820 dispatches = 87.91/dispatch)

Salaries of Administrative Staff (112,540/1,820 dispatches = 61.84/dispatch)

Utilities (90,000/1,820 dispatches = 49.45/dispatch)

|Allocation of the Components of Warehouse | | |

|Costs | | |

| |SOFTDRINK |BEER |

|1. Warehouse Rent | | |

| [ (1,500 x 40%) x 233.33 ] / 2 |P 70,000 | |

| [ (1,500 x 60%) x 233.33 ] + 70,000 | |P 280,000 |

|2. Security Services | | |

| [ (1,500 x 40%) x 73.73 ] / 2 | 22,120 | |

| [ (1,500 x 60%) x 73.73 ] + 22,120 | | 88,480 |

|3. Salary of Dispatcher | | |

| (637 x 42.86 ) / 2 | 13,650 | |

| (1,183 x 42.86 ) + 13,650 | | 64,350 |

|4. Salaries of Checker | | |

| (637 x 79.67 ) / 2 | 25,375 | |

| (1,183 x 79.67 ) + 25,375 | | 119,625 |

|5. Salaries of Warehousemen | | |

| (637 x 87.91 ) / 2 | 28,000 | |

| (1,183 x 87.91 ) + 28,000 | | 132,000 |

|6. Salaries of Administrative Staff | | |

| (637 x 61.84 ) / 2 | 19,694.50 | |

| (1,183 x 61.84 ) + 19,694.50 | | 92,845.50 |

|7. Utilities | | |

| (637 x 49.45 ) / 2 | 15,750 | |

| (1,183 x 49.45 ) + 15,750 | | 74,250 |

| |_________________ | ________________ |

|TOTAL ALLOCATED WAREHOUSE COSTS |P 194,589.50 |P 851,550.50 |

Still this computation have the same results as when the costs are combined into two different cost pools.

4. What is the appropriate costing system Mr. Buenafe should apply?

In order for a costing system to be relevant, it must provide among others the cost data about particular cost object such as products that use the resources of the organization.

If Mr. Buenafe used the relative proportion of the commissions from both products as the allocation bases of the warehouse costs, 722,803.19 or 69% of total warehouse cost will be allocated to beer while 323,336.88 or 31 % of total warehouse cost will be allocated to soft drinks.

Using this costing system, Mr. Buenafe will beg off from the contract because after allocating the warehouse cost, the soft drink contract resulted to a loss. The sales commission arising from the soft drink contract was not able to cover up the costs incurred in its distribution.

But this costing system has many disadvantages:

This simple cost allocation uses a lumped all indirect cost in a single cost pool, and allocating this based on the sales commission will create erroneous data. Likewise, with the number of products sharing the resources, and where products do not consume the resources uniformly, a single allocation basis will understate the costs of one product while overstating the cost of the other product. This is referred to as cross-subsidization.

Proof:

RECONCILIATION:

Cost of Beer from the first method using the sales commission: 722,803.19

Adjustments for:

Overstatement of Fixed Cost:

460,600.00 x (69.09% - 60%) (41,879.57)

Overstatement of Variable Cost:

585,540.00 x (69.09% - 65%) (23,962.61)

Total Adjustments (65,842.18)

Cost of Beer from the second method using ABC 656,961.01

Cost of Soft drinks from the first method using the sales commission: 323,336.81

Adjustments for:

Understatement of Fixed Cost:

460,600.00 x (40% - 30.91%) 41,879.57

Understatement of Variable Cost:

585,540.00 x (35% - 30.91%) 23,962.61

Total Adjustments 65,842.18

Cost of Soft drink from the second method using ABC 389, 179.06

Since the soft drink contract commences at the half of the year, the computation will be

Cost of Soft drink from the second method using ABC- 389, 179.06/2 = 194,589.53

Cost of Beer from the second method using ABC- 656,961.01 + 194,589.53 = 851,550.54

As we can see from the reconciliation, there are overstatement and understatement of costs. This costing system will lead Mr. Buenafe to wrong decision.

But if Mr. Buenafe will use the Activity-Based Costing System using the appropriate allocation bases, the decision of Mr. Buenafe will change because the beer contract resulted to a loss while soft drink contract resulted to a gain.

Using this costing system, it will lead to an accurate allocation because:

a. The costs were allocated using the appropriate cost drivers. The costs were assigned to the cost objective that caused it.

b. Comparing the sales commission and the ABC costing, there are cost distortions.

c. Better allocation of costs leads to more correct costing and better management decisions because these decisions are based on correct cost information.

d. Indirect cost must be properly allocated because it constitutes significant percentage in the whole cost.

Points emphasized in ABC:

a. ABC systems trace more costs as direct cost

b. ABC systems create homogeneous cost pools linked to different activities,

c. For each activity-cost pool, ABC system seek a cost-allocation base that has a cause-and-effect relationship with cost in the cost-pool.

The benefit of ABC system is that it provides information to make better decisions. But the benefits of ABC must be weighed against its measurement and implementation costs.

The main cost and limitations with ABC are the operational complexities and measurements necessary to implement it. It requires mgt to estimate cost of activity pools and identify cost drivers for these pools to serve as cost allocation bases. Making the many measurements is costly. Activity rates needed to be updated regularly.

As ABC gets very detailed and more cost pools are created, more allocations are necessary to calculate activity cost for each cost pool. This increases the chances of misidentifying the costs of different activity cost pools.

The appropriate costing system that Mr. Buenafe must use is the ABC system. It was discovered that Mr. Buenafe must continue the soft drink contract while he must do some actions regarding its beer contract. Maybe, make adjustments in its variable cost incurred.

5. What will be the decision of Mr. Buenafe regarding the soft drink contract after using the appropriate costing system?

Using ABC system as the costing system in allocating the cost, Mr. Buenafe will not beg off from the soft drink contract as it is profitable in its half year of operations. Since the beer contract is losing, Mr. Buenafe could use the ABC costing in its decision. Since the beer contract is consuming more cost, maybe Mr. Buenafe could do some actions regarding the variable costs charged in distributing this product. Another way is that Mr. Buenafe can make some adjustments in terms of the sales commission. He could ask the manufacturer to increase the sales commission for beer in order to cover up the costs incurred.

6. What is the effect of the time period covered by the soft drink contract to the allocation?

It is of great importance to consider the time period covered by the soft drink contract in the allocation of the warehouse costs. Since the contract of the soft drink commenced in the middle of the year and for a given annual warehouse cost of P 1,046,140.00 which are properly allocated using appropriate bases or cost drivers for each component, only ½ of the amount should be allocated to soft drink and “reallocate back” the other ½ to beer. In these sense, the costs assigned to each contract is the one truly incurred within the scope of its operations. In effect, if the time period is not considered, the amount of cost allocated to soft drink is overstated thus understating its net profit while the cost allocated to beer is understated and its net profit is overstated.

REFERENCES:

• Mejorada, D. Nenita. Cost Accounting, Second Edition

• Horngen, et al,. Concepts and Practices, Twelfth Edition

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