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This report analyses the costs associated with two of Coffee Beans Inc. products, Moana Loa and Malaysian blends based on two different costing methodologies, namely the traditional job costing system that the company uses so far and the Activity Based Costing (ABC).
ABC provides us with a more detailed and accurate estimation of the real cost of the products and it can serve as the basis for suitable strategic decisions, concerning products mix, pricing, suppliers and market positioning.
A major issue that have to be concerned is the discontinuation or not of Malaysian blend. Appropriate recommendations and alternative solutions are being provided in order to facilitate the strategic decision process and help the Board of Directors to go to the right direction that will optimize our product mix, strengthen our position in the market and boost our operating profit.
Traditionally, companies used costing based solely on direct labor or machine hours in order to allocate indirect costs to products. A more recent approach is the Activity Based Costing (ABC) that first accumulates overhead costs for each of the activities of an organization, and then assigns the costs of activities to the products, services, or other cost objects that caused that activity.
The present report will investigate the costs structure of two products of Coffee Bean Inc., Moana Loa and Malaysian. Initially, the so far applied traditional method will be presented. Then, the refined costing system of Activity Based Costing will be examined. Following there will be a comparison of the two methods with an effort to locate points that will reveal inconsistencies in costing and subsequent pricing of the products. The aim is Coffee Bean Inc. to identify precisely which drivers dominate the cost of each blend and actively adjust its product mix, pricing, purchasing and marketing strategy.
Conclusions and recommendations on possible routes of problems, solutions or strategies to follow will be thoroughly discussed and a crystal clear image of the "cause-effect" relationship of all stages and factors in each blend will be drawn.
2. Traditional Costing method
The first method of costing used to evaluate the Coffee Bean products' costs and profitability is the traditional costing method. This provides an initial base for comparison in order to assess the Malaysian and Moana Loa coffee blends against each other.
The traditional costing method classifies all manufacturing costs of products into three big categories, these being direct materials, direct labor and manufacturing overhead. Direct materials and labor are straightforward in the case of Coffee Bean Inc. Company data provided breakdown these costs for both coffee blends in question. On the other hand, the third category of manufacturing overhead may not always be as accurate as it is applied based on a weighted average for the products. The calculation of all three categories is discussed in the following paragraphs.
Data is provided for the direct cost of Moana Loa and Malaysian coffees as well as the direct labor costs (Table 1). In addition, a prediction of production in pounds for each product is 100.000 and 2.000 respectively. Given the above inputs, the following direct costs are extracted:
Moan Loa Direct Material Cost
Moan Loa Direct Labor Cost
Malaysian Direct Material Cost
Malaysian Direct Labor Cost
The manufacturing overhead budget provides us with a schedule of costs for coffee bean products including all other costs other than direct labor and materials. In order to determine the indirect manufacturing costs, the overhead rate used to charge all the indirect manufacturing costs is determined. The product of the overhead rate along with the direct cost allocated to each coffee brand provide a figure of the indirect manufacturing overhead which can be allocated to each blend.
Overhead rate = = 5ïƒ¨Overhead rate = Total budgeted manufacturing overhead / budgeted direct labor cost
Having all three categories of conventional costing and the quantity of each blend required for production, a budgeted cost and price of each blend can be acquired ( Table 2). It is evident that the budgeted cost and price of Moana Loa blend is higher than that of Malaysian, reaching values of $6.00 and $5.00 respectively. Given that the direct material cost is the only different driver in value, and all other costs are found as a product of common rates with quantity, this result is expected. Higher direct material cost of Moana Loa, leads to higher price.
This result is seen with skepticism since the data provided for the different activities does differ with blend choice, and to assign manufacturing costs based on weighted averages of production is a simplistic way to go. The effect the different activity costs provided per blend have on their budgeted costs is investigated in the following sections.
3. Activity Based Costing (ABC)
The second method of costing used to evaluate the coffee bean products' costs and profitability is the Activity Based Costing (ABC) method. This method will reveal the link between performing particular activities like purchasing, materials handling, quality control, processing beans which consist our indirect costs, and the demands those activities make on the organization's resources.
In contrast with traditional method, in ABC the expenses incurred to produce individual units of particular products (Malaysian and Moana Loa coffee blends) are separated from the expenses needed to produce these different products.
Concerning the activities of roasting, blending and packaging, they have the same overhead cost per hour. Hence, they all can be included in a pool of processing costs since they are homogeneous with a cost allocation base or hours of processing. (Table 4).
Activity Cost-Allocation Base Budgeted Activity Budgeted Cost
Roasting Roasting hours 96.100 $961.000
Blending Blending hours 33.600 $336.000
Blending Packaging hours 26.000 $260.000
Processing Beans Processing hours 155.700 $1.557.000
In order to proceed to ABC method, the cost allocation rate is needed. Using data in table 4 of the appendix the following results arise.
Purchasing Cost Allocation Rate =$579.000 Budg. Cost / 1.158 Budg. Activity= $500
Material handling Allocation Rate =
$720.000 Budg. Cost / 1.800 Budg. Activity= $400
Quality control Allocation Rate =$144.000 Budg. Cost / 600 Budg. Activity= $240
Roasting Allocation Rate =$961.000 Budg. Cost / 96.100 Budg. Activity= $10
Blending Allocation Rate =$336.000 Budg. Cost / 33.600 Budg. Activity= $10
Packaging Allocation Rate =$260.000 Budg. Cost / 26.000 Budg. Activity= $10
In addition to the cost allocation rate, the rate per unit of each cost allocation base used to allocate indirect costs (activities) to the products is required. Activities are bonded with activity drivers. Thus, activities like purchasing, materials handling and quality control are linked with cost drivers known as transaction drivers where the number of times an activity occurs matters. On the other hand, processing activities are associated with duration cost drivers where the time needed for the completion of each activity is of importance. Each activity uses a specific cost allocation base. Retrieving data from Table 5 of the appendix, the amount allocated to the cost base used is found.
Activity Cost-Allocation Base Moana Loa Malaysian
Purchasing Purchase orders 4 4
Materials handling Setups 30 12
Quality control Batches 10 4
Processing beans Processing hours 1.600 32
â€¢ Purchase Orders=Exp. Sales (pounds)/Purchase order size (pounds)
â€¢ Setups=Setups per Batch x Batches
â€¢ Batches=Expected Sales(Pounds)/Batch Size (Pounds)
â€¢ Processing Hours= Processing Beans*Expected Sales (pounds)/100
In order to proceed to the calculation of the budgeted costs and prices of the two blends, the contribution of each direct and indirect (activity) cost per pound are calculated (Table 6 of the Appendix).
â€¢ Purchasing Cost per Pound=Purchasing Orders Used*Purchasing Cost Alloc Rate/Setups per batch.
â€¢ Materials Handling=Setups Used*Set Up Cost Allocation Rate/Setups per batch.
â€¢ Quality Control per pound=Batches Used*Batches Cost Allocation Rate/ Setups per batch.
â€¢ Processing Beans per pound=Process. Hrs Used* Process. Hrs Cost Allocation Rate/ Setups per batch
Having completed all the above steps we are in a position to find the total budgeted cost and price of each blend (Table 7 of the Appendix).
It is deduced that budgeted cost and price of Moan Loa blend is lower that of Malaysian having values $4.82 and $6.27 respectively contrary to the values of $7.54 and $9.80 of Malaysian blend. The number of the outputs affects the budgeted costs and prices of the blends. Economies of scale are introduced in the production of Moana Loa contrary to Malaysian coffee. In the first blend the expectation of 100.000 pounds sales allows bigger distribution of cost per pound. At the same time forecasted sales of 2.000 pounds for Malaysian coffee do not let the product to benefit through this method as the cost and the price is higher.
The contradicting results arising from the application of the two costing methods (traditional and ABC) are further analyzed.
4. Comparison Between the Results of Traditional Costing and Activity Based Costing for Coffee Bean Inc.
The first evident difference which arises from the application of the two aforementioned costing methods is the significant gap between the final cost figure of each method (and consequently the big difference in the price of each blend). With traditional costing the cost of Moana Loa is 25% higher than in the case of ABC ($6.00 Traditional, $4.82 ABC) while for Malaysian blend the cost when calculated with the traditional method is almost 51% lower than what in the ABC case ($5.00 Traditional, $7.54 ABC). The reason for this cost (and consequently price) difference is the fundamental difference between the two costing systems which is the assumption in traditional costing that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.
Another thing that becomes clear with the use of ABC but could not be observed with the use of the traditional costing method is the fact that the item with the lower material cost is actually the one with the higher price (the cost of the raw material for the Malaysian blend is 24% lower than the cost of raw material for the Moana Loa blend while the price of the Malaysian blend is 56% higher than the price of the Moana Loa blend). The above observation can be explained by the fact that in the case of the Moana Loa blend we have economies of scale, so the total cost per pound is lower than the total cost per pound of the Malaysian blend, even thought the cost for the raw material is higher for the Moana Loa and lower for the Malaysian blend.
In general after observing the results of the two methods we may say that in the case of the traditional costing method the usually deceiving results that we obtain do not allow us to notice and take actions for cases of mispricing, do not always make clear the cases of economies of scale, do not make us wonder about the effectiveness of our product mix an so on. It is obvious that without accurate cost figures, management cannot make accurate observations and take actions regarding important issues.
Following that comparison between the existing costing system, which is based on the direct labor cost for the production of each products, and the Activity Based Costing we can derive the following interesting conclusions:
â€¢ The actual cost of Malaysian coffee is higher than the price that it is currently sold ($7.54 vs. $6.50). Hence, a loss of $1.04 per unit is occurring from selling that product.
â€¢ The two products are both mispriced. Moana Loa is overpriced (the price should be lower than the current, after the addition of the 30% mark-up at he new cost). Malaysian is underpriced and a loss is incurring with every unit sold. It is almost certain that more of the remaining 13 products of the company will be also over- or underpriced under the existing costing system. That leads in a totally wrong pricing strategy and is a marketing drawback when the products take their position in the selves of the stores.
â€¢ The total operating profit will be lower in the case we decide just to adjust our prices to the new cost estimations and continue selling the products. Moreover, there is a high probability that the sales of Malaysian, will drop dramatically because it will be too expensive for the quality it offers.
â€¢ From the cost structure under the two different costing methods, it is notable that the indirect cost for Moana Loa is 25% with traditional costing and only 6.72% with ABC and for Malaysian the respective percentages are 30% and 53,6%.
â€¢ It is clear that there are economies of scale for Moana Loa that sells in high volumes and the cost of raw materials account for a very high percentage of the total cost (87.1%) under the ABC method. The indirect costs are allocated in large quantities of the blend, resulting in a very good product (raw seeds are more expensive than other varieties) with a reasonable price.
The above conclusions make clear that some corrective strategic actions are absolutely necessary in order to re-launch our product mix in a more efficient way, offer value-for-money to our customers and take our business forward.
Based on the cost analysis under ABC system and the conclusions that were derived, the following recommendations are made:
â€¢ We should discontinue the production and selling of Malaysian blend since it is currently a source of loss for our business.
â€¢ If there is a special reason that we do not want to discontinue the marketing of Malaysian coffee (ex. to cover the needs of some good and special customers that want a wide variety of products), there is an alternative solution that can turn Malaysian coffee profitable. The solution is to make an accurate sales projection and unify the sales orders throughout the year in only one order that will cover the demand for the whole year. The proper storing conditions will ensure the optimal preservation of the product. In order to illustrate that argument with numbers, if the budgeted 4 orders of 500 pounds each were unified in one order of 2000 pounds (total annual estimated sales) the cost per pound will drop from $7.54 to $4.63 per pound and there will be a profit. We can maintain the price at $6.50 (in order not to confuse the market) and have a profit of $1.87 per unit or decrease the price to $6.02 (30% mark-up) and gain market share with the competitive lower price of the product. Maybe, the reason that Malaysian does not sell much and has very low market share is that it is expensive in relation to its quality.
â€¢ We should examine the cost of all other 13 products in order to discover other products that may be inexpedient to continue producing.
â€¢ We should conduct a Market Research in order to gather information of the consumer behavior regarding the coffee consumption and determine their willingness-to-pay for more premium products. That will help us decide if we shall maintain the price of Moana Loa at $7.80 and promote it as a premium quality coffee in order to have a high mark-up (61.8%) or lower the price to $6.27% (30% standard mark-up), increase sales and gain market share from competitors.
The need for change in our pricing policy will bring about the need for other strategic changes as well. We shall plan our tactics towards our strategy taking into account other relevant information. We have to make better sales projections based on historical data of our sales and on market intelligence. The proper market research will provide us with information about consumer preferences and needs, so we can fine-tune our product mix' quality and price offered to the consumers. We will then proceed to a more detailed segmentation of the market and promote the right product to the right consumer segment (ex. premium coffee for willing-to-pay customers and less expensive blends to customers that consider coffee a commodity). Also, information about competitors' moves that can come from our suppliers and wholesale customers would be extremely valuable for the mapping of the market field.
Another aspect that we should look into is the origin of our raw materials and the location of our suppliers. We have 15 different raw materials (coffee beans) that come from various suppliers. If we could group suppliers together based on their location, we could design a coordinated purchasing plan that would unify the orders and decrease a lot the transportation cost. As an immediate result, we will have a higher operating profit per product.
Overall, this new costing system will help us become more efficient, more productive, make better strategic decisions and our products will became more competitive with the new representative pricing that will be based on the real cost and the real value they carry to the consumer. That will strengthen our position in the market and empower the company to expand in other consumer goods market as well.