Question: Company Luau Kona and Blue Jamaican

a. Using a plant-wide rate based on machine hours to assign manufacturing overhead cost to products In this approach the manufacturing overhead is based on machine hours. The manufacturing overhead application rate has been has been provided as $54.00 per machine hour. The following table list on the first row the number of machine hours required for each coffee type. The second row show the manufacture overhead for one kilo of coffee, based on the machine hours for one kilo of each coffee and the rate for machine hour | Luau Kona | Blue Jamaican | Machine hours required for the manufacture of one kilo of coffee. | 0.04 | 0.02 | Manufacturing overhead application rate for one kilo of coffee | 0.04 x $54.00 = $2.16 | 0.02 x $54.00= $1.08 |

Requirement: Determine the total unit product cost of one kilogram of the Luau Kona coffee and one kilogram of the Blue Jamaican coffee.
In order to calculate the total unit product cost of one kilogram of coffee, we need to add:
- Direct material cost
- Direct labour cost
- Manufacturing overhead application rate | Luau Kona | Blue Jamaican | Direct material cost | $5.20 | $3.10 | Direct labour cost | $0.20 | $0.37 | Manufacturing overhead application rate | $2.16 | $1.08 | Total unit product cost of one kilogram | $7.56 | $4.55 |

b. Using multiple predetermined overhead rates based on the departmental rates In this approach the manufacturing overhead is calculated by adding different department rates. The table below lists the overhead application rate for each department. The first two departments use hours as the measurement unit, while the Packaging department uses unit / number of packages. Departmental | Roasting | Blending | Packaging | Department activity base | Machine hours | Direct labour hours | Number of packages | Overhead application rate | $19.05 | $22.60 | $0.29 |

The following table lists on the first three rows the activity for each coffee type in each department (columns 3 and 5). The columns 4 and 6 list the calculation for one kilo of coffee in each department. This calculation uses the overhead application rate for each department (table above) and the activity time in each department. The last row shows the calculation of the manufacturing overhead for one kilo of coffee, as the sum of the departmental rates for one kilo of coffee. Department | Application base | Luau Kona | Blue Jamaican | Roasting | Machine hours | 0.01 | 0.01 x $19.05= $0.1905 | 0.02 | 0.02 x $19.05= $0.381 | Blending | Direct labour hours | 0.04 | 0.04 x $22.60= $0.904 | 0.05 | 0.05 x $22.60= $1.13 | Packaging | Number of packages | 1.00 | 1.00 x $0.29= $0.29 | 1.00 | 1.00 x $0.29= $0.29 | Manufacturing overhead rate for one kilo of coffee, based on the departmental rates | $0.1905 +$0.904 +$0.29 _________ $1.3845 | | $0.381 +$1.13 +$0.29_________$1.801 |

In order to calculate the total unit product cost of one kilogram of coffee, we need to add:
- Direct material cost
- Direct labour cost
- Manufacturing overhead rate for one kilo of coffee, based on the departmental rates | Luau Kona | Blue Jamaican | Direct material cost | $5.20 | $3.10 | Direct labour cost | $0.20 | $0.37 | Manufacturing overhead rate for one kilo of coffee, based on the departmental rates | $1.3845 | $1.801 | Total unit product cost of one kilogram | $6.7845 | $5.2710 |

c. Using activity-based costing In this approach the manufacturing overhead is determined using activity-based costing, which means that for each activity we estimate a cost per kilo. This estimation could be based on previous experience. The table below list the cost per unit of activity in the last column, which is calculated as estimated cost for the year, divided by Estimated Activity for the year.

Activity cost pool | Activity Measure | Estimated Cost for the year | Cost per unit of activity | Quality control | # of batches | 800 | $105,400 | $131.7500 | Material handling | # of setups | 1,400 | $225,700 | $161.2143 | Purchasing | Purchase orders | 3,100 | 660,300 | $213.0000 | Roasting | Hours | 135,000 | 1,234,000 | $9.1407 | Blending | Hours | 39,000 | 225,700 | $5.7872 | Packaging | Hours | 42,000 | 140,900 | $3.3548 |

Requirement i: Determine the amount of manufacturing overhead cost per kilogram of the Luau Kona coffee and the Blue Jamaican coffee.
Requirement ii: Determine the total unit product cost of one kilogram of the Luau Kona coffee and one kilogram of the Blue Jamaican coffee.

| Luau Kona | | Expected sales | 90,000 kg | | | Activity-based costing | Batch size | 5,000 kg | # of batches | 90,000 / 5,000= 18 | 18 x $131.7500= $2,371.50 | Setups (per batch) | 2 | # of setups | 18 batches * 2= 36 | 36 x $161.2143= $5,803.71 | Purchase order size | 18,000 kg | # of orders | 90,000 / 18,000= 5 | 5 x $213.00= $1,065.00 | Roasting time for 100kg | 1.5 | Total hours (for 90,000 kg) | 1.5 x (90,000 / 100)= 1,350 | 1,350 x $9.1407= $12,339.945 | Blending time per 100kg | 0.5 | Total hours | 0.5 x (90,000 / 100)= 450 | 450 x $5.7872= $2,604.24 | Packaging time for 100kg | 0.3 | Total hours | 0.3 x (90,000 / 100)= 270 | 270 x $3.3548= $905.796 | Manufacturing overhead cost to produce 90000 kg | $25090.191 | Manufacturing overhead cost to produce 1 kg | $25090.191 / 90,000= $0.28 |

| Blue Jamaican | | Expected sales | 5,200 kg | | | Activity-based costing | Batch size | 400 kg | # of batches | 5,200 / 400= 13 | 13 x $131.7500 = $1,712.75 | Setups (per batch) | 4 | # of setups | 13 batches x 4= 52 | 52 x $161.2143= $ 8,383.14 | Purchase order size | 400 | # of orders | 5,200 / 400= 13 | 13 x $213.00 = $2,769.00 | Roasting time for 100kg | 2.5 | Total hours(for 5,200 kg) | 2.5 x (5,200 / 100)= 130 | 130 x $9.1407 = $1,188.30 | Blending time per 100kg | 1.5 | Total hours | 1.5 x (5,200 / 100)= 78 | 78 x $5.7872 = $451.40 | Packaging time for 100kg | 0.3 | Total hours | 0.3 x (5,200 / 100)= 15.6 | 15.6 x 3.3548= $52.33 | Manufacturing overhead cost to produce 5,200 kg | | | | $14556.92 | Manufacturing overhead cost to produce 1 kg | | | | $14556.92 / 5200 = $2.80 |

In order to calculate the total unit product cost of one kilogram of coffee, we need to add:
- Direct material cost
- Direct labour cost
- Manufacturing overhead cost for one kilo of coffee, using activity-based costing. | Luau Kona | Blue Jamaican | Direct material cost | $5.20 | $3.10 | Direct labour cost | $0.20 | $0.37 | Manufacturing overhead rate for one kilo of coffee, based on the departmental rates | $0.28 | $2.80 | Total unit product cost of one kilogram | $5.68 | $6.27 |

d. Prepare a comparative partial income statement that illustrates the gross margin and gross margin percentage In this approach we calculate the gross margin and gross margin %, for each of the three method used above. | Luau Kona | Blue Jamaican | Selling price | $9.50 | Gross margin | Gross margin % | $6.05 | Gross margin | Gross margin % | Total unit cost / kg using | | | | | | | Plant wide overhead | $7.56 | $9.50 - $7.56= $1.94 | $1.94 / $9.50= 20.42% | $4.55 | $6.05 - $4.55= $1.50 | $1.50 / $6.05= 24.79% | Multiple predetermined overhead | $6.78 | $9.50 - $6.78= $2.72 | $2.72 / $9.50= 28.58% | $5.271 | $6.05 - $5.271= $0.7790 | $0.78 / $6.05= 12.88% | Activity-based costing | $5.68 | $9.50 - $5.68= $3.82 | $3.82 / $9.50= 40.22% | $6.27 | $6.05 - $6.27= -$0.22 | -0.22 / $6.05=-3.63% |

e. Explain to the controller the implication of using a plant-wide rate as a base for assigning manufacturing overhead costs to products.
Using the plant-wide rate based on machine hours to assign manufacturing overhead is not the best solution in the current setup. This approach has two main flaws:
- the machine hours require for the manufacture of the product differ from one department to another
- activities that are required in the manufacturing process but do not use machines, are not included. In order to demonstrate the first flaw, let's have a look at the second approach that uses department rates. Each product requires Roasting and Blending department time, but the number of units is different from one department to another. For example, Luau Kona coffee needs 0.01 machine hour and 0.04 labour hours in Blending department. But the overhead rate for these departments is different: $19.05 for Roasting and $22.60 for Blending. So, the plant-wide approach using one machine hour rate is not accurate in this case. The result also reflects this. The overhead for Luau Kona calculated using the plant-wide method is $2.16, and the overhead calculated using departmental rates is $1.38. The second big issue with the plant-wide rate approach is that it doesn't include labour that is not using machines, like QA.
The activity-based costing approach allows the controller to include these activities. The cost per unit of activity can be estimated based on the previous experience. This method is more complex and requires more calculations, but it is more precise. When we compare the results with the plant-wide rate, there are big differences. My recommendation is to use the activity-based costing approach, because it offers more flexibility in defining the activities and departments involved in the process of delivering a product.