Costello Corporation produces two grades of wine from grapes that it buys from California growers. It produces and sells roughly 600,000 gallon jugs per year of a low cost, high-volume product called Valley Fresh. Costello also produces and sells roughly 200,000 gallons per year of a low-volume, high-cost product called Costello Valley. Costello Valley is sold in 1-liter bottles. Based on recent data, the Valley Fresh product has not been as profit table as Costello Valley. Management is considering dropping the inexpensive Valley Fresh line so it can focus more attention on the Costello Valley product. The Costello Valley product already demands considerably more attention than the Valley Fresh line. Frankie Costello, president and founder of Costello, is sceptical about this idea. He points out that for many decades the company produced only the Valley Fresh line, and that it was always quite profitable. It wasn't until the company started producing the more complicated Costello Valley wine that the profitability of Valley Fresh declined. Prior to the introduction of Costello Valley, the company had simple equipment, simple growing and production procedures, and virtually no need for quality control. Because Costello Valley is bottled in 1-liter bottles, it requires considerably more time and effort, both to bottle and to label and box, than does Valley Fresh. The company must bottle and handle 4 times as many bottles of Costello Valley to sell the same quantity as Valley Fresh, since there are approximately 4 litres in a gallon. Valley Fresh requires 1 month of aging; Costello Valley requires 1 year. Valley Fresh requires cleaning and inspection of equipment every 2,500 gallons; Costello Valley requires such maintenance every 250 gallons. Frankie has asked the accounting department to prepare an analysis of the cost per gallon using the traditional costing approach and using activity-based costing. The following information was collected.

Valley Fresh Costello Valley

Direct materials per gallon $1.35 $3.60 Direct labour cost per gallon $0.75 $1.50 Direct labour hours per gallon 0.05 0.10 Total direct labour hours 30,000 20,000

Activity Cost

Pool Cost Driver Estimated overheads Expected use of cost drivers Expected use of cost drivers per product Valley Fresh Costello Valley

Grape processing Cart of grapes $146,000 8,000 6,000 2,000

Aging Total months $420,000 3,000,000 600,000 2,400,000 Bottling and corking Number of bottles $210,000 1,400,000 600,000 800,000 Labelling and boxing Number of

bottles $140,000 1,400,000 600,000 800,000 Maintain and inspect equipment Number of

inspections $234000 1,040 240 800 Required: Write a memo to Frankie Costello providing a brief description of what is activity based costing as well as an explanation of how the traditional approach can result in distortions.

Hint: You should support your discussion by calculating and comparing the total manufacturing cost per gallon for both products under both traditional costing systems as well activity based costing.

Assessment Information This material has been reproduced and communicated to you by or on behalf of Kaplan Business School pursuant to Part VB of the Copyright Act 1968 ('Act'). The material in this communication may be subject to copyright under the Act. Any further reproduction or communication of this material by you may be the subject of copyright protection

under the Act. Kaplan Business School is a part of Kaplan Inc., a leading global provider of educational services. Kaplan Business School Pty Ltd ABN 86 098 181 947 is a registered higher education provider CRICOS Provider Code 02426B.

CASE STUDY 2 Curtis Rich, the cost accountant for Hi-Power Mower Company, recently installed activity based costing at Hi-Power's St. Louis lawn tractor (riding mower) plant where three models—the 8-horsepower Bladerunner, the 12-horsepower Quickcut, and the 18-horsepower Supercut—are manufactured. Curtis's new product costs for these three models show that the company's traditional costing system had been significantly under costing the 18-horsepower Supercut. This was due primarily to the lower sales volume of the Supercut compared to the Bladerunner and the Quickcut.

Before completing his analysis and reporting these results to management, Curtis is approached by his friend Ed Gray, who is the production manager for the 18-horsepower Supercut model. Ed has heard from one of Curtis's staff about the new product costs and is upset and worried for his job because the new costs show the Supercut to be losing, rather than making, money.

At first, Ed condemns the new cost system, whereupon Curtis explains the practice of activity based costing and why it is more accurate than the company's present system. Even more worried now, Ed begs Curtis, "Massage the figures just enough to save the line from being discontinued. You don't want me to lose my job, do you? Anyway, nobody will know." Curtis holds firm but agrees to recompute all his

calculations for accuracy before submitting his costs to management. Required: Draft a response from Curtis to Ed Gray. Assessment Information COMMONWEALTH OF AUSTRALIA Copyright Regulations 1969 This material has been reproduced and communicated to you by or on behalf of Kaplan Business School pursuant to Part VB of the Copyright Act 1968 ('Act'). The material

in this communication may be subject to copyright under the Act. Any further reproduction or communication of this material by you may be the subject of copyright protection under the Act. Kaplan Business School is a part of Kaplan Inc., a leading global provider of educational services. Kaplan Business School Pty Ltd ABN 86 098 181 947 is a registered higher education provider CRICOS Provider Code 02426B.

CASE STUDY 3 Gonzalez Company produces one product, Olpe. Because of wide fluctuations in demand for Olpe, the Assembly Department experiences significant variations in monthly production levels. The annual master manufacturing overhead budget below is based on 300,000 direct labour hours. In July, 27,500 labour hours were worked. The master manufacturing overhead budget for the year and the

actual overhead costs incurred in July are as follows. Overhead costs Master budget Actual results for July Variable

• Indirect labour $ 300,000 $ 26,000 • Indirect material $ 150,000 $ 11,350 • Utilities $ 90,000 $ 8,050 • Maintenance $ 60,000 $ 5,400 Fixed

• Supervision $ 144,000 $ 12,000v • Depreciation $ 96,000 $ 8,000 • Insurance and taxes $ 60,000 $ 5,000 Total $ 900,000 $ 75,800 Required: (A) Prepare a budget report for the month of July 2014, comparing actual results with budget data based on the flexible budget. Were costs effectively controlled? Explain.

(B) Prepare the flexible budget graph showing total budgeted costs assuming monthly production levels range from 25,000 to 30,000 direct labour hours (use increments of 2,500 direct labour hours).