CaseA ssignm ent1

A ctivity Based Costing

Morelli Electric Motor Corporation manufactures electric motors for commercial use. The
company produces three models, designated as standard, deluxe, and heavy-duty. The company
uses a job-order cost-accounting system with manufacturing overhead applied on the basis of
direct-labor hours. The system has been in place with little change for 25 years. Product costs
and annual sales data are as follows:

For the past 10 years, the company's pricing formula has been to set each product's target price
at 110 percent of its full product cost. Recently, however, the standard-model motor has come
under increasing price pressure from offshore competitors. The result was that the price on the
standard model has been lowered to $110.
The company president recently asked the controller, Why can't we compete with these other
companies? They're selling motors just like our standard model for 106 dollars. That's only a
buck more than our production cost. Are we really that inefficient? What gives?
The controller responded by saying, I think this is due to an outmoded product-costing
system. As you may remember, I raised a red flag about our system when I came on board last

year. But the decision was to keep our current system in place. In my judgment, our productcosting system is distorting our product costs. Let me run a few numbers to demonstrate what I
mean.
Getting the president's go-ahead, the controller compiled the basic data needed to implement an
activity-based costing system. These data are displayed in the following table. The percentages
are the proportion of each cost driver consumed by each product line.

Required:
1. Compute the target prices for the three models, based on the traditional, volume-based
product-costing system.
2. Compute new product costs for the three products, based on the new data collected by the
controller. Round to the nearest cent.
3. Calculate a new target price for the three products, based on the activity-based costing
system. Compare the new target price with the current actual selling price for the standardmodel electric motor.
4. Write a memo to the company president explaining what has been happening as a result of
the firm's traditional, volume-based product-costing system.
5. What strategic options does Morelli Electric Motor Corporation have? What do you
recommend, and why?

CaseA ssignm ent1

California Creamery, Inci

California Creamery, Inc. (CCI) owned and operated 14 retail ice cream stores spread
throughout Southern California, form San Luis Obispo to San Diego. CCIs stores sold
only the highest quality, ultra premium ice cream. They offered 25 different ice cream
flavors. Many of the CCI flavors were exotic, such as Polynesian Fantasy, MangoLemon Supreme, and Multi-Nut Twist. But CCI also sold a few traditional ice cream
flavors, such as vanilla, chocolate, strawberry, and coffee. Some of the flavors were
very popular, but a few of the exotic flavors sold in low volumes.
CCI produced its own ice cream. Originally the ice cream was produced in the garage
of the companys founder, Will Forgey. But the company outgrew the garage, and Will
had since leased a building to house CCIs production activities. As CCI had Grown,
Will had been able to afford more expensive, automated manufacturing equipment that
blended the flavors and packaged the liquid ice cream in preparation for freezing. CCIs
most significant production costs were for raw materials, particularly cream, sugar, and
the special flavor ingredients, and for the acquisition, operation, and maintenance of the
production equipment.
All of CCIs products were sold at the same retail price. Will set the prices to yield,
roughly, a markup of 100 percent on average full production costs. CCIs 2004 budget
included manufacturing overhead of $600,000. To estimate product costs, Will spread
this overhead cost to products based on a proportion of the direct labor used in the
production process. CCIs total direct labor costs for 2004 was $300,000, so Will
charged the overhead to products a a rate of 200 percent of direct labor costs.
One day in a casual conversation, Louise Fettinger, Wills neighbor and a controller of a
small manufacturing company, suggested that Wills pricing policy was not very smart.
Louises intuition was that the costs of producing CCIs various flavors were very
different. She thought those differences should be reflected in the prices charged, or
CCIs profits would vary as the mix of products sold varied.
Louise suggested that Will re-estimate product costs using what she classed and
activity based cost system. Toward that end, she suggested that he identify the major
activities whose costs were included in the companys overhead costs. Then he should
apply those costs to products based on the products consumption of each of those
activities. In response to Louises suggestion, Will prepared the information shown in
Exhibit 1.

Then, again following Louises suggestion, he decided to calculate the costs of two
illustrative products as an experiment to see if Louises new cost system idea produced
any material differences. He asked Louise to take here best guess as to where he
might find the most significant differences, if any existed. After Will described the
products to her, Louise suggested that he use Polynesian Fantasy and Vanilla as the
test product examples. Exhibit 2 provides data pertinent to those two products.

Exhibit 1
California Creamery, INC.
2004 Budgeted Manufacturing Overhead Costs
Activity
Budgeted
Driver of the Activity
Costs
Costs
(000)
Purchasing
Material handling
Blending
Freezing
Packaging
Quality Control
Total Manufacturing
Overhead costs

$ 80
95
122
175
110
18

Purchase orders
Setups
Blender hours
Freezer hours
Packaging machine hours
Batches

Budgeted
Activity Level
for the Cost
Driver
909
1,846
1,000
1,936
1,100
286

$ 600

Exhibit 2
California Creamery, INC.
Two Product Examples (2004 data)
Direct material
Direct labor
Budgeted production and sales
Batch size
Setups
Purchase order size
Blender time
Freezer time
Packaging machine time

Polynesian Fantasy
$2.00/gallon
1.20/gallon
2,000 gallons
100 gallons
3 per batch
50 gallons
0.6 hour per 100 gallons
1.0 hour per 100 gallons
0.3 hour per 100 gallons

Vanilla
$1.80/gallon
1.20/gallon
100,000 gallons
2,500 gallons
3 per batch
1,000 gallons
0.3 hour per 100 gallons
1.0 hour per 100 gallons
0.2 hour per 100 gallons

Assignment:
Analyze the case and answer the following questions
1. Compute the full production cost (per gallon) of the Polynesian Fantasy and
Vanilla products using:
a. Wills old costing method, and
b. The new costing method (Louises suggestion).
2. What are the effects, if any, of changing the companys costing method?
Specifically, are the differences between the two costing methods material in
terms of:
a. Their effect on individual product costs?
b. Their effect on total company profits? (Assume no changes in any
operating decisions, such as prices and production volumes.)
If there are material differences, why do they exist?
If there are no material differences, why do they not exist?
3. What should Will do now? Explain.

Copyright by Kenneth A. Merchant and Wim A. Van der Stede.