Kate Ice Cream Company

Q1. Why is the Vanilla flavor so much MORE profitable when measured using activity-based costing compared to the traditional method of allocating overhead?

Using traditional allocation method, we calculate Overhead cost based only on a single cost driver – total number of gallons of ice cream produced. It means that we assume that cost of creating simple vanilla flavor must be the same as cost of creating Marshmallow Caramel Delight or Gingerbread Cheesecake Supreme. So, we use an average cost driver - $1 740 000/1 500 000 gallons = $1.16 per gallon → 500 000 gallons*$1.16 per gallon = $580 000 of Overhead cost of production Vanilla flavor. Total production cost = $580 000 (Overhead) + $200 000 (Direct materials) + $125 000 (Direct labor) = $905 000, while sales of Vanilla flavor = $750 000.

This method is not significant, because we don’t take into account the difference in number of ingredients or number of batches which are needed to create different ice cream flavors. For example, number of ingredients we use to produce Gingerbread Cheesecake Supreme is 25, when for producing Vanilla favor we need only 5. In this way, Overhead cost of production ice cream flavors can’t be measured by the average cost driver not paying attention for activities allocated to production different ice cream flavors.

Using ABC, we can calculate Overhead cost more carefully. For Vanilla ice cream Overhead cost can be calculate as follows:

• Gallons of ice cream = 500 000 gallons*$0.50 per gallon = $250 000
• Number of batches = 25 batches*$880 per batch = $22 000
• Number of ingredients = 5 ingredients*$2700 = $13 500

Total production cost = $285 500 (Overhead) + $200 000 (Direct materials) + $125 000 (Direct labor) = $610 500, while sales = $750 000 → Gross profit = $750 000 - $610 500 = $139 500 (compare with the traditional way of cost calculating, when Gross profit = -$155 000).

Q2. Why is the Gingerbread Cheesecake Supreme flavor so much LESS profitable when measured using activity-based costing compared to the traditional method of allocating overhead?

Here we can use the same explanation as in Q1 for opposite situation – production Gingerbread Cheesecake Supreme. While we use traditional allocation method we can reduce Overhead costs for Gingerbread Cheesecake Supreme favor production – when cost driver is the same for every ice cream type ($1.16 per gallon), the less number of gallons we produce, the less ice cream production costs for us. In that case, to produce 200 000 gallons of Gingerbread Cheesecake Supreme favor we need 200 000 gallons*$1.16 per gallon = $232 000 (less that for production simple Vanilla favor, which costs $580 000 for 500 000 gallons).

But, when we use ABC, we have to take into account that for Gingerbread Cheesecake Supreme favor production we need to use the biggest number of batches (235 batches) and also the big number of ingredients (25 ingredients). In this way, for Gingerbread Cheesecake Supreme ice cream Overhead cost can be calculate as follows:

• Gallons of ice cream = 200 000 gallons*$0.50 per gallon = $100 000
• Number of batches = 235 batches*$880 per batch = $206 800
• Number of ingredients = 25 ingredients*$2700 = $67 500

Total production cost = $374 300 (Overhead) + $250 000 (Direct materials) + $100 000 (Direct labor) = $724 300, while sales = $600 000 → Gross profit = $600 000 - $724 300 = -$124 300

Q3. Is there any way to save the Gingerbread Cheesecake Supreme flavor?

In order to save the Gingerbread Cheesecake Supreme flavor in our menu, we need to reduce cost of production this type of ice cream or increase sales. Comparing production cost of Gingerbread Cheesecake Supreme flavor with Double Dutch Chocolate Brownie favor we can see that they are almost the same - $724 300 for Gingerbread Cheesecake Supreme flavor and $753 400 for Double Dutch Chocolate Brownie favor. But, Double Dutch Chocolate Brownie favor is much more profitable for company than Gingerbread Cheesecake Supreme flavor.