DECISION MAKING

You are required to answer the following three questions. The assignment must be completed individually and submitted before the due date to avoid any late penalties. Please make sure you follow the guidelines noted in your subject outline especially those relating to presentation of written work, late policy and academic integrity.
Assessment Description
CASE STUDY 1
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
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Costello Valley
Direct materials per gallon
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$1.35
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$3.60
Direct labour cost per gallon

$0.75

$1.50
Direct labour hours per gallon

0.05
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0.10
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Total direct labour hours

30,000

20,000
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Activity Cost Pool
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Cost Driver
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Estimated overheads
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Expected use of cost drivers
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Expected use of cost drivers per product
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Valley Fresh
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Costello Valley
Grape processing

Cart of grapes

$146,000

8,000

6,000
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2,000
Aging

Total months

$420,000

3,000,000

600,000
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2,400,000
Bottling and corking
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Number of bottles
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$210,000

1,400,000
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600,000
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800,000
Labelling and boxing
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Number of bottles
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$140,000

1,400,000
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600,000
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800,000
Maintain and inspect equipment

Number of inspections
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$234000
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1,040

240
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800
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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.

 

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