NOVA School of Business and Economics
The present paper serves to exhibit the group’s analysis on the case “Ericson Ice Cream Company”. This case presents a situation where a company faces a problem that could be solved through a more accurate management accounting.
Ericson Ice Cream Company was a successful ice cream producer which had seen its profit increasingly growing in the past years. As a consequence if its success, it decided to increase its products’ portfolio and started producing two additional flavours which could be charged at a higher price and, therefore, originated higher profits. However, after the introduction of these two new flavours, the company’s operating margins decreased. The company’s controller, Laura Tunney, could not understand the reason for this result as, according to her analysis, the two new products were more profitable than the others the company was already producing. At the same time, Ericson’s manufacturing manager, Jeffrey Donald, emphasized the fact that the production of the new products consist of a more complex process as it requires more time in setting up machines and monitoring the whole procedure. Consequently, he thought that increasing the company’s product portfolio would not benefit the company. After some consideration, Laura Tunney arrived to the conclusion that probably her analysis was incorrect due to an inaccurate allocation of the company’s indirect costs. She had chosen to use the same method the company applied before and allocated the total amount of the indirect expenses on the basis of each product’s labour cost. In this sense, she calculated the percentage of the total amount of direct costs that each product consumed so she could then assign the total amount of the indirect expenses according to that percentage. Hence, she used a traditional costing system. However, the more complex process which the company has now to engage made the total amount of indirect expenses increase. Ericson now produces a low-volume specialty product which means more scheduling, more set ups, more and better quality control personnel and an information system able to support all these activities. Inevitably, the company’s higher indirect costs originate higher cost distortions which, in turn, affect the analysis of the products’ profitability. Taking this fact into consideration, Tunney considered applying a cost allocation system that employs cause-and-effect drivers rather than an arbitrary allocation base so that indirect costs are allocated to each product in a more accurate way. This way, she would be able to identify, more approximately, what are the manufacturing margins of each product. In this sense, she decided to try allocating indirect costs through the ABC system. This method allocates indirect costs to different activities (groups of several tasks which are associated to certain objects) so that then it is possible to allocate them to products according to the activities’ cost drivers (units of an activity that cause the change in activity's cost). To do this, Laura Tunney needed first to identify the major activities that take place in the organization and, therefore, she decided to collect information among different departments across the company and make some research. First of all, before identifying any activity, she found that the indirect expense category “Fringe Benefits” should be amounted as 40% of both the indirect labour costs and the direct labour costs rather than be considered as a category with an expense of £480 000. In this sense, this value should be removed from the indirect expenses’ categories and the amount of indirect labour costs should be increased in 40%: Indirect Labour cost = £600 000 x 1.40 = £840 000. This is the value that should be used when allocating indirect labour costs to different activities. Regarding the rest of the fringe benefits’ value, it should only be considered when analysing...
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