CASE 1:
ZAUNER ORNAMENTS

Table of Contents

I. CASE SUMMARY 2 II. POINT OF VIEW 2 III. STATEMENT OF THE PROBLEM 2 IV. FRAMEWORK OF ANALYSIS 2 V. ANALYSIS 2 VI. DISCUSSION OF RESULTS AND RECOMMENDATION 4 VII. APPENDIX 5 VIII. REFERENCES 9

I. CASE SUMMARY

Chia-yi Yu, the new controller of Zauner ornaments, decided to research Zauner’s current costing methods. She approached her senior analyst, Yung Chen, to prepare an analysis of unit-product costs for each of Zauner’s products, namely small glass ball ornaments, large glass ball ornaments, and specialty glass ball ornaments.

Using information from the sales department, Chen calculated the cost per box using traditional volume-based costing system and as a result, small glass ornaments’ cost is more than twice higher than its selling price, which means the company is losing money. David Metz, the directory of Operations, analyzed the results and suggested to redo the calculations and to try allocating overhead to each product based upon direct materials and direct labor. Chen calculated the cost per box using Metz’ suggested approach and found that product costs are below current sales price. Yet, Chia-Yu was not fully convinced of this approach and realized that activity-based costing (ABC) system might reflect Zauner’s product costs more accurately and serve as a basis for better product-pricing decisions.

II. POINT OF VIEW

The analysis of Zauner Ornaments’ cost allocation per product will be taken from Chia-yi Yu’s perspective, being the new controller, who aims to review and provide more accurate costs and improve product-pricing decisions.

III. STATEMENT OF THE PROBLEM

The problem is to choose among traditional volume-based costing, direct materials-and-direct labor-based costing and activity-based costing that will reflect Zauner’s product costs most accurately with the goal of improving product-pricing decisions.

IV. FRAMEWORK OF ANALYSIS

Using the information provided in the case, we shall determine the best base for allocating plant-administration costs. We have to determine the cost drivers of each overhead cost and calculate the costs for each product on a per-box basis using activity-based costing (ABC) system. Given the other two costs per product using Volume- Based Costing and Direct Materials-and Direct Labor-Based Costing provided in the case, the group has to define the difference of three approaches and justify why ABC provides the most accurate costing. From these, we will verify if any changes should be taken by the management about Zauner’s pricing strategy and give our recommendations.

V. ANALYSIS

To get the unit cost per ornament using Activity Based Costing, we need to allocate the plant administration cost to each product by choosing which cost driver to use. Cost drivers should generally be based on a cause-and-effect relationship between the driver and the specific cost being considered. As given in the article, plant administration cost includes three components which are supervision costs, labor relation costs, and clerical costs. The first component, supervision cost, is directly related to overseeing the productivity and the performance of employees. Accordingly, the best cost driver is the number of supervision hours or the percentage of plant capacity used. However, no information was given on the number of supervision hours used by each product line and Table 5 does not provide the breakdown of the 70% plant capacity used per product line. The next best thing is to use the number of batches since the more batches of ornaments are being produced the more it requires supervision which was given in Table 3. For the second component, the cost of labor relations, the best cost driver is direct labor cost as provided in Table 5 because this cost component can be related to the cost of managing employer and employee relationship. The number of employees is proportionate to the direct labor cost. Since the number of plant personnel working on each product line was not provided in Table 5, the next best cost driver to use is the direct labor costs allocated to each product line. For the last component, the clerical cost, we can use either the number of ornaments per product or the number of batches since this cost relates to the production of ornaments. Since no details were given as to the exact amount for each component of plant administrative overhead cost, a common cost driver for these components is the next best thing to do in allocating said overhead. Supervision and clerical costs have a common cost driver which is the number of batches, but labor relations cost does not. However, we can consider that labor relation is connected with supervision. So, we can choose the number of batches as the next best cost driver. The calculated allocation of plant administration cost is provided in Table 6: Allocated Plant Administration Cost.

Before calculating for the cost of each product using Activity Based Costing, we need to determine other overhead costs by identifying first the rest of the cost driver per overhead. This is summarized in Table 7: Overhead Item and its Cost Driver. Calculations of each product using ABC are seen in Table 8: Calculation of Product Costs: Activity Based Costing System. Analyzing the results, we can clearly see that the small and large colored glasses are losing $7.21 and $1.75, respectively, while only the specialty ornaments give profit of $6.45, as shown in Table 9: Comparison of Selling Price versus Three Costing Methods.

Chen’s use of traditional volume-based costing system turned out incorrect since he only considered allocating the budget for overhead based on the number of ornaments of planned production. According to an article in www.financialsupport.weebly.com, traditional costing systems utilize a single, volume-based cost driver. This is the reason why the traditional product costing system distorts the cost of products. Each time a unit of product is manufactured, it is assumed that cost is incurred. This assumption makes sense for certain direct costs. The assumption does not work for activities that are not performed directly on the product units. Volume-based costing systems often result in over costing high-volume products and under costing low-volume products which is evident in Table 9.

Traditional costing systems assign cost directly to products, rather than to activities first and then to product units. It reports information about what is spent, but not why it is spent. By using the traditional costing system, it means that all the costs incurred have to be allocated to a product. This is the reason why small glass ball ornaments incur a loss of $12.12 per box and large glass ball ornaments incur a loss of $2.56 as shown in Table 9: Comparison of Selling Price versus Three Costing Methods. Only the special glass ball ornaments is profitable which show a gain of $8.57 with its selling price.

Unit costs computed by Chen using direct material-direct labor costing are better than the traditional volume-based costing approach since the unit cost per box is less than its selling price. Profits for small colored glass, large colored glass, and special ornaments are $0.71, $0.63, and $2.49, respectively. Yet, this approach is still not sufficient. According to www.businessdictionary.com, he considered costs of all items such as raw materials, standard and specialized parts, and sub-assemblies required to assemble or manufacture a complete product plus the cost of employees or workers who are directly involved in the production alone to allocate total overhead cost.

Using activity-based costing (ABC), Yu identified the activities that Zauner performs in manufacturing the different products, and then assign the indirect costs to products based on how much of these activities are used for each product. From www.accountingcoach.com, activity-based costing allocates costs to the activities that are the real cause of the overhead and then assigns the cost of those activities only to the products that are actually demanding the activities.

Compared with traditional volume-based costing, ABC provides the same direction of loss and gain of money but ABC cost for each product is much lower than what was computed using traditional volume-based costing. According to www.investopedia.com, an activity based costing (ABC) system recognizes the relationship between costs, activities and products, and through this relationship assigns indirect costs to products less arbitrarily than traditional methods. Thus, ABC provides more accurate unit costs. Figures below provide comparison of selling prices with each costing system used for each of the three products.

Using the results from the ABC system, Zauner Ornaments must make changes in their pricing strategy. Zauner Ornaments may benchmark on market prices of the same product versus theirs, and from there they may look at changes in pricing strategy and cut down their expenditures. They have to compute for the breakeven prices taking into consideration the prices and costs of the three products to know the lowest selling price they can provide to the market. They can also lower production of small colored glass and large colored glass and increase production of specialty products since based on ABC system these products contribute more profit. Zauner Ornaments can consider buying direct materials in bulk to get discounts and reduce costs. Zauner Ornaments may think of ways to improve labor relations cost by increasing labor efficiency such as increasing the number of ornaments produced per worker.

Zauner ornaments can also use the information gathered from the ABC system to further reduce the cost per unit. From Table 8, the small colored glass has the highest allocation of overhead because it has the highest number of batches. Because of this cost driver, this product line has the highest allocated project scheduling cost, machine setup cost and plant administration cost. Zauner could make improvements to reduce the number of batches for small colored glass so they can achieve a lower cost per unit and sell them at a profitable price. The same strategy could also be applied to the large colored glass. However, Zauner should take note that this could increase the price of the specialty ornaments since the overhead cost allocated to it may increase. VI. DISCUSSION OF RESULTS AND RECOMMENDATION

The analysis shows that Zauner Ornaments decided on selling price per product based on market prices of the same products. Costing analysis was not even considered to come with its selling price. When Yu and Chen used traditional volume based costing for overhead allocation, the cost per box of each product presented an alarming situation. This showed that small colored glass and large colored glass were being sold at a loss, while specialty ornaments are the only product that contributed profit.

A reverse cost per box of each product was calculated when they used to allocate overhead based on direct material and direct labor. It shows that three products do not incur loses but are very near to breakeven, therefore there’s a very small margin of profit per product.

The results from the first two costing systems are unsatisfactory and so a third approach, the activity based costing, was used. This gave the most accurate approach to allocate overhead costs. Using ABC system, it was realized that small colored glass and large colored glass were actually being sold at a loss, and specialty ornaments contribute profit same with the traditional-based costing but with much less actual loss and gain.

With this, the group recommends Zauner Ornaments to: * Benchmark on market prices of the same product versus theirs to get idea on how to change their price strategy * Compute for its breakeven prices to know the lowest selling price they can provide to the market * Lower production of small colored glass and large colored glass and increase production of specialty products * Buy direct materials in bulk to get discounts and reduce costs * Think of ways to improve labor relations cost by increasing labor efficiency such as increasing the number of ornaments produced per worker

The use of Activity-Based Costing woke up Zauner Ornaments that they are selling ornaments lower than its cost. They should think of ways to change their pricing strategy with the help of the results from ABC but should still consider the pricing provided by the market. VII. APPENDIX
Table 1: Calculation of Product Costs: Volume-Based Costing System

Table 2: Calculation of Product Costs: Direct Materials-and-Direct Labor-Based Costing System

Table 3: Activity Data by Product

Table 4: Historical Five-Year Plant-Administration Costs and Other Data

Table 5: Plant Data by Product Line

Table 6: Allocated Plant Administration Cost

Table 7: Overhead Items and Their Cost Drivers

Table 8: Calculation of Product Costs: Activity-Based Costing System

Table 9: Comparison of Selling Price versus Three Costing Methods

Figure 1: Small colored glass Selling Price versus Three Costing Methods

Figure 2: Large colored glass Selling Price versus Three Costing Methods

Figure 3: Specialty Ornaments Selling Price versus Three Costing Methods

VIII. REFERENCES

http://financialsupport.weebly.com/activity-based-costing-abc-and-traditional-costing-systems.html http://www.businessdictionary.com/definition/direct-material.html#ixzz2BODBD55L http://www.investopedia.com/terms/a/abc.asp#ixzz2BOKZ34Ka
http://www.accountingcoach.com/online-accounting-course/35Xpg01.html