McDonalds Activity Based Costing Sales example essay topic

1. Costing System 1.1 Illustrate the costing system currently used by Devon Quality in Cost Centre 3 The costing system currently used by Devon Quality Dairy in the Cost Centre 3 is a traditional costing system this is because in this case study Devon Quality Dairy are allocating there expenses to products using volume based drivers. In this case study, the resources consumed by Devon's Cost Centre 3 are depreciation, labour, utilities and other, which are all of the costs that have been incurred in production that cannot be traced directly to the products. The traditional costing system uses a single plant wide overhead rate based on output volume to allocate factory overhead costs to the products. The factory overhead rate is total factory overhead divided by the cost driver. In this case the cost driver is pounds of butterfat.

The pounds of butterfat sold are chosen as the cost driver for Devon's because the pounds of butterfat are attributed to Devon's purchase costs, which were indicated in the information in the article. 1.2 Comment on the appropriateness of "pounds of butterfat" as an allocation base for the overhead costs in Cost Centre 3. Would you suggest a different allocation base? Pounds of Butterfat as an allocation base for the overhead costs in Cost Centre 3 aren't very appropriate. This is because the costs in Cost Centre 3 don't actually reflect the specific activities that are performed or costs in this cost centre.

In Cost Centre 3, the overhead costs are depreciation, labour and utilities. These overhead costs have absolutely no correlation with the amount of pounds of butterfat used per product. Depreciation expense is incurred from the devaluation of the factories machinery, labour is used to operate and maintain this machinery, and utilities are all of the utility costs that are incurred by the factory within their daily operations. It is because of this that we believe that Devon should use a different allocation base, and that base should be annual batches produced.

We believe that annual batches produced will be a far better allocation base because from these batches you are able effectively determine the actual volume of ice creams mix that is produced by Devon Quality Dairy. Knowing the annual batches that are produced are a far better method of cost allocation because this cost driver actual does reflect the indirect costs that are incurred by Devon. Depreciation, labour and utilities are directly correlated to the amount of batches that are produced, because the more batches that are produced the more the cost are going to increase. Therefore, we deem that Devon Quality Dairy would be far advantaged if they were to change there cost driver from the pounds of butterfat, to batches produced annually. 1.3 Reconstruct the cost allocation formula for the overhead rates shown in Table 2.

Factory Overhead Rate = Total Factory Overhead Annual Batches Produced = 3618620 2000 = $1809.31 per batch Delivery Overhead Rate = Total Delivery Cost Annual Batches Produced = 1908400 2000 = $954.20 per batch Selling and Administration Overhead Costs = Total Selling and Admin Costs Annual Batches Produced = 293600 2000 = $146.80 per batch 2. McDonald's Order 2.1 What are the relevant costs to this order? Relevant cost are defined as costs that change under two or more decision alternatives, thus the relevant costs associated with the McDonalds order are: The required purchase of 3 additional refrigerated delivery trucks Extra gas and maintenance cost for the trucks equaling $2000 per truck per summer months. Five additional summer drivers, costing $3500 per month per driver through out the summer months Therefore the relevant costs are: Direct Costs (1,000,000 $1.607) = $1,607,000 Indirect Costs (1,000,000 (0.173+0.191+0.014) ) = $278,000 Additional Truck Costs (3 150,000) = $450,000 Extra Gas and Maintenance Costs (2,000 3 3) = $18,000 Additional Summer Drivers (3,500 5 3) = $52,500 Total Relevant Costs for McDonalds Order = $2,405,500 2.2 Should the order be accepted? To determine if we will accept this McDonalds order, we need to find out what the unit contribution margin is for this special offer. Unit Contribution Margin = Unit Sales Price - Unit Variable Cost McDonald's Order Unit Sales Price 1.94 less Unit Variable Costs Direct Costs 1.607 Indirect Costs 0.278 1.885 Unit Contribution Margin 0.055 From these calculations we found that the McDonald's Order will produce a positive contribution margin of $0.055 per unit.

Meaning that for this order Devon would receive a contribution margin of $55,000 (0.055 1,000,000). Therefore, we believe that Devon Quality Dairy should accept the McDonald's Order. 2.3 Will your decision change if all orders have to yield the desired target of 15% mark-up? McDonald's Order with 15% Mark-up Unit Sales Price 1.94 less Unit Variable Costs Direct Costs 1.607 Indirect Costs 0.278 15% Mark-up 0.283 2.168 Unit Contribution Margin -0.228 From these calculations we found that the McDonald's order with the 15% mark-up will produce a negative contribution margin of -$0.228 per unit.

Meaning that from this order Devon would receive a contribution margin of -$228,000 (-0.228 1,000,000). Therefore, our decision would change if all orders had to yield the desired target of 15%. When the 15% mark-up is desired we would advise Devon not to accept the order. 4.4 Identify any qualitative issues that should be considered prior to accepting this order. The first issue that Devon Quality Dairy has to consider is weather the extra mast order of 1,000,000 gallons would cause a strain on the quality of the product?

Even though the new equipment enables the company to double its packaging capacity but the production process still remains the same and with the sudden new product requirement would this set the quality of the products back. They will have to determine if the other departments such as the quality control can cope with the increase number of productions. They will need to evaluate if they would need to increase their services from the administrative department, as they will have to take up new ordering processes for this new contract. This could also result in unseen future costs that might be involved, with a new ordering system. An important issue that Devon should consider is how their existing managers will react to the special price they are offering to McDonalds? Currently they are charging their existing customers $2.121 per gallon but if they accept the McDonalds order they will be charging them only$1.94 per gallon.

A problem could also arise from their current and potential customers who might also demand the same price that McDonalds will receive. Which could in the long run lose these customers or mean that Devon would have to find improved ways to lower their costs, to be able to sell at this lower price. They would have to determine how long the McDonald's Ordering contract would last for, and if the price could be evaluated after each financial year. This would become apparent because costs can change from year to year, and if Devon isn't able to change their prices to correlate with the added costs, they could be losing significant amounts of money through the McDonalds deal in the future.

3. Activity Based Costing 3.1 Briefly comment if activity based costing would benefit Devon Quality Dairy? Activity based costing (ABC) would benefit Devon significantly, because ABC is a cost allocation system that assigns costs to products, services, or customers based upon the consumption of resources caused by activities. While there current costing system is a volume-based costing system, that is only useful when direct labour and materials are the only predetermined factors of production.

In the case of Devon where they have many predetermined factors ABC analysis is far more accurate. With ABC resources are assigned to activities, from which these activities are assigned to cost objects based upon the activities used by the company. It is because of this we that an activity based costing system would be extremely beneficial for Devon's analysis of their costs. 3.2 Devon Quality Dairy have asked you to undertake an initial ABC analysis using the following activity breakdown. Activity Total Costs Cost Driver Cost Driver Cost Rate Amount Pasteurisation and Separation 1,111,550 Raw Milk Gallons 60,000,000 $0.0185 Bottling Labour 500,000 Gallons of Mix 11,600,000 $0.0431 Other Mix Department Costs 2,007,070 Number of Batches 2000 $1,003.5350 Delivery Stop Costs 840,000 Number of Stops 84000 $10.0000 Other Delivery Costs 1,068,000 Gallons of Mix 11,600,000 $0.0921 Selling and Administration 293,600 Number of Orders 84,000 $3.4952 3.3 Prepare a new cost estimate for the McDonald's order using the activity cost rates. McDonald's Order using Activity Based Costing Sales Revenue 1,940,000 less Variable Costs Direct Cost 1,607,000 Indirect Costs Factory Overhead - Pasteurisation and Separation 55,500 - Bottling Labour 43,100 - Other Mix Department 0 98,600 Delivery Costs - Delivery Stop Costs 46,800 - Other Delivery Costs 92,100 138,900 Selling and Administration - Selling and Admin Costs 16,357 16,357 253,857 1,860,857 Contribution Margin from McDonalds Order using ABC $79,143 Calculation Using batch size as an allocation base. a One batch can produce 10,000 gallons of mix.

So 2,000 batches can produce 20,000,000 gallons of mix. b Devon currently produces 20,000,000 gallons of mix, but only sells 11,600,000 gallons of mix, meaning they will not incur any additional batch costs for the McDonalds Order. c With the McDonalds Order Devon will need to deliver to 30 restaurants, three times per week. After using the activity based costing to calculate the overhead costs in relation to the operations involved with McDonald's order, we believe that Devon should accept the special order. With the application of ABC, we found that Devon actually incurs less costs than it did before, when it was operating under the traditional costing system. With ABC being a more in-depth system of costing you could be reasonably sure of the costs and would definitely accept the McDonalds Order.