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    Activity Based versus Traditional Costing

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    P4-4A Mendocino Corporation produces two grades of wine from grapes that it buys from California growers. It produces and sells roughly 3,000,000 liters per year of a low-cost, high-volume product called CoolDay. It sells this in 600,00 5-liter jugs. Mendocino also produces and sells roughly 300,000 liters per year of a low-volume, high-cost product called Litemist. Litemist is sold in 1-liter bottles. Based on recent data, the CoolDay product has not been profitable as LiteMist. Management is considering dropping the inexpensive CoolDay line so it can focus more attention on the Litemist product. The LiteMist product already demands considerably more attention than the CoolDay line.

    Tyler Silva, president and founder of Mendocino, is skeptical about this idea. He points out that for many decades the company produced only the CoolDay line, and that it was always quite profitable. It wasn't until the company started producing the more complicated LiteMist wine that the profitability of CoolDay declined. Prior to the introduction of LiteMist, the company had simple equipment, simple growing and production procedures, and virtually no need for quality control. Because LiteMist is bottled in 1-Liter bottles, it requires considerably more time and effort, both to bottle and to label and bpx than does CoolDay. The company must bottle and handle 5 times as many bottles of LiteMist to sell the same quantity as CoolDay. CoolDay requires 1 month of aging;LiteMist requires 1 year. CoolDay requires cleaning and inspection of equipment every 10,000 liters; LiteMist requires such maintenance every 600 liters.
    Tyler has asked the accounting department to prepare an analysis of the cost per liter using the traditional costing approach and activity-based costing. The following information was collected.

    CoolDay LiteMist
    Direct materials per liter $0.40 $1.20
    Direct labor cost per liter $0.25 $0.50
    Direct labor hours per liter 0.05 0.09
    Total direct labor hours 120,000 25,000

    Expected use of Cost Drivers per product
    Activity Cost Pools Cost Drivers Estimated Overhead Expected use of Cost Drivers CoolDay LteMist
    Grape processing Cart of Grapes $145,860 6,600 6,000 600
    Aging Total months 396,000 6,600,000 3,000,000 3,600,000
    Bottling and corking Number of bottles 270,000 900,000 600,000 300,000
    Labeling and boxing Number of bottles 189,000 900,000 600,000 300,000
    Maintain and inspect equipment Number of inspections 240,800 800 350 450

    Answer each of the following questions. (round all calculations to three decimal places)
    (a) Under traditional product costing using direct labor hours, compute the total manufacturing cost per liter of both prodcuts
    (b) Under ABC (Activity-Based-Costing) prepare a schedule showing the computation of the activity-based overhead rates (per cost driver)
    (c) Prepare a schedule assigning each activity's overhead cost pool to each product, based on the use of cost drivers, include a computation of overhead cost per liter.
    (d) Compute the total manufacturing cost per liter for both products under AB
    (e) Write a memo to Tyler Silva discussing the implications of your analysis for the company's plans. In this memo provide a brief description of ABC, as well as an explanation of how the traditional approach can result in distortions.

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    Solution Summary

    The solution explains the calculations relating to activity based costing and traditional costing