Dream chocolate company choosing a costing system answers

ISSUES IN ACCOUNTING EDUCATION American Accounting Association Vol. 28, No. 3 DOI: 10.2308/iace-50464 2013 pp. 637–652

Dream Chocolate Company: Choosing a Costing System

Kip R. Krumwiede and W. Darrell Walden

ABSTRACT: This case is about a small, but real, company, Dream Chocolate (D.C.), which makes custom-labeled, high-quality candy bars for special events and advertising purposes. Like many small companies, D.C. has an inadequate costing system and needs a much better one as it starts to get bigger orders. In Part A of this case, students learn how to analyze a company’s situation, identify relevant information in a case that is presented in a less-structured format, evaluate the pros and cons of different costing approaches, recommend an approach, and suggest ways to implement it. In Part B, they develop and calculate costs based on their recommended approach. The case also helps increase students’ understanding of the applicability of various costing methods typically covered in cost and managerial accounting courses.

Keywords: instructional case; cost accounting; job order costing; process costing; operation costing; activity-based costing; and accounting information systems.

INTRODUCTION

K ay Johnson sat back in his chair wondering about what he had just done. He accepted a

special order from a national supplier of wellness products for 200,000 chocolate bars at a

20 percent discount from the usual price. It is a new type of bar and the company provided

the recipe. The company also hinted about a second order for 150,000 bars if the first order was

successful. Kay sighed and thought, ‘‘I hope we can make a profit on this order, because we are going to have to increase our capacity big-time to fill it. Wish I knew what the cost will be.’’

OVERVIEW OF COMPANY

Dream Chocolate (D.C.) is the major product line of Salmon River Foods, the spawn of a trip

on the Middle Fork of the Salmon River in Boise, Idaho. President Kay Johnson was burned out by

30 years in the food service industry and decided to sell his business and begin anew. Quite by

accident, he received a call asking if his new company Salmon River Foods would consider selling

Kip R. Krumwiede and W. Darrell Walden are both Associate Professors at the University of Richmond.

We thank David E. Stout, Shannon L. Charles, and Nick Fessler for helpful comments. We also thank Kay Johnson, owner of Dream Chocolate, for his support throughout the project.

This case is based on a real company, but quantitative information used in the case is disguised for confidentiality purposes.

Published Online: March 2013

637

chocolate bars. Kay’s son Rob was employed by a German company and was frequently flying to

Europe and returning with wonderful chocolate as family gifts. Kay wondered how he could

produce European-style chocolate (no waxes or preservatives) in the U.S. With his son’s help, he

found a supplier in Germany who would ship to the U.S. Kay purchased a chocolate factory in

Boise and began production in April 2002. Kathleen Wasson, Vice President, oversees the creative

arts department and assists Kay in managing the plant.

What started with one basic milk chocolate bar has grown to include two milks, two darks, two

semi-sweets, one white, one bittersweet, and other adaptations involving various ingredients such as

coffee, berries, and fresh mint. The chocolate is wonderful, but the real charm of the product is its

custom labeling. For individual snacking, D.C. bars are sold in specialty markets, fine gift stores,

and other locations. They are also available for corporate events and celebrations, such as weddings

and birthdays. The website at www.dreamchocolate.com provides more information about its

various product offerings.

Competitive Pressures

D.C. is a small company trying to survive in an industry with many players. Competition can

come from the many custom chocolate bar providers on the Internet (e.g., Custom Candy

Creations, Totally Chocolate, Carson Wrapped Hershey’s Chocolates, to name a few), as well as

from big chocolate companies (e.g., Mars, Nestlé, and Hershey’s) who can always beat D.C. on

price. As such, it pursues any type of order it can get. The company’s niche is European-style

custom chocolate bars and labeling, and it is known for its flexibility and speed. For instance, a

small customer order can be printed, labeled, and ready for pickup or shipping within an hour if

the company already has the label in its system. Few, if any, of D.C.’s competitors can match

this turnaround time or its combination of high-quality bars, variety of flavors, and custom

labeling.

Lagging Sales

Sales were about $500,000 in 2010. Demand was increasing in August and September 2010,

which are normally weaker months due to fewer special events. This gave D.C. management great

hope, but the continued national recession hurt sales in 2011 (as it did for most companies). When

asked about the issues D.C. faced at that time, Kay Johnson said that:

We need more business to utilize our capacity and make a profit. As we do so, the main

issue will be training people. It takes up to three months to train people adequately. Also,

custom labeling needs to be more effectively marketed. This is our best margin area. If we

focused our business on low-margin, high-volume chocolate bars we could be vulnerable

to customers dropping us for another supplier.

Costing Issue

It is now 2012 and D.C. is starting to get bigger orders, such as the one for 200,000 bars.

D.C. bars are also now being sold in some REI1 outlets around the country. As is common with

small companies, Salmon River Foods has an inadequate costing system. For example, it is

unable to compute actual costs per order or per bar. For pricing purposes, Kay estimates the

costs of each type of bar using his experience and knowledge of ingredient prices and what he

pays out each month in expenses. Each order is different, and typically ranges from 150 bars to

1 REI is a national retail chain of outdoor clothing and equipment products (see: www.REI.com).

638 Krumwiede and Walden

Issues in Accounting Education Volume 28, No. 3, 2013

http://www.dreamchocolate.com

http://www.REI.com

10,000 bars. It is difficult for the company to estimate an accurate cost for an order for pricing

purposes, so he really never knows whether orders are profitable or not. Kay wondered how to

accurately determine the cost for this new special order—the biggest order in the company’s

history by far!

Adding to the challenge are limited resources for more accounting work. D.C. employs an

hourly wage Boise State University accounting graduate part-time to do its monthly bookkeeping

(books are closed at the end of the year). A local CPA does its financial statements, taxes, and

provides occasional advice. However, Kay now needs a new type of costing system to provide

accurate cost estimates, and is wondering what type of costing system makes sense for his small but

growing business.

PRODUCTION PROCESS

Making high-quality chocolate bars is a challenging process. The bulk chocolate must be

melted and flavored just right before being tempered, which is a process that aligns the crystals in

molten chocolate to produce the best texture balance of firm and creamy. Kay Johnson described

the challenges in achieving the right formula:

It’s a high-end process. The chocolate is temperamental, and, much like wine, there are

many different kinds, qualities, and layers of flavor. We try to make ours less sugary and

more pure, so that chocolate is the first thing you taste.

D.C. employs a full-time Master Chocolatier, who oversees the entire production process, fills

in at any area when there is a need, and performs most of the product inspections. Exhibit 1

provides a flow chart of the 3,000 square foot factory and the seven production areas, each of which

are discussed next.

1. Receiving Area

As soon as the bulk chocolate is received in the Receiving Area, it is dated and placed in the

Imported Chocolate Storage area. Organic chocolate, which comes from a U.S. supplier, has a

separate shelf from the rest of the bulk chocolate.

2. Pouring Area

After the Pouring Area is cleaned and cleared of all non-organic chocolate (if necessary), the

bulk chocolate is brought to the melting pots to be melted. Any flavors (e.g., mint or lavender oil)

and ingredient additives (e.g., huckleberries or nuts) are added to the pots at the right time. This

process consists of tempering and pouring the chocolate into molds, then moving the molds to the

Cooling Tower. There are separate racks for organic and non-organic bars.

3. Inspection Area

Bars are taken out of the molds on the Chocolate Breakdown Table, and the newly formed chocolate

bars are placed on a rack in the Inspection Area. In the Inspection Area, the Master Chocolatier weighs

the bars and visually inspects each one for flaws. Flawed bars are sent back to the Chocolate Rework

Storage area to be re-melted and used again. There is very little waste in the process and no by-products.

4. Foiling Area

After the chocolate is inspected, it is sent to the Foiling Area to be manually foiled. After

foiling, the chocolate bars are either sent immediately to the Labeling area to be completed as ‘‘retail

Dream Chocolate Company: Choosing a Costing System 639

Issues in Accounting Education Volume 28, No. 3, 2013

stock’’ or put on the Foiled Product shelves to be held for future orders as ‘‘bright stock.’’ D.C. likes to keep bright stock on hand to be able to quickly fill future orders for the more common sizes and

flavors. Bright stock boxes are dated and used based on first-in first-out (FIFO).

5. Labeling Area

In the Labeling Area, foiled chocolate bars are manually labeled and prepared for shipping.

Some retail stock orders are labeled with standard, pre-designed D.C. labels describing the flavor,

type of chocolate, and possibly a theme (e.g., ‘‘The Wine-Lovers Bar’’ or ‘‘Think Pink Dark Chocolate’’). Other orders are for ‘‘Custom Label Bars’’ for advertising or special events (e.g., weddings, store openings). These labels include things like company logos, photos, paintings, and

even resumes and personal business cards. D.C. requires a 150-bar minimum and charges an

additional amount for the custom label design costs, which can vary significantly depending on

customer needs. VP Kathleen Wasson edits the many retail and custom labels produced for D.C.

bars. All labels are printed on D.C.’s color laser printer.

6. Finished Product Storage Area

All labeled bars are stored in the Finished Product Storage Area until shipped or picked up by

customers. The company produces significant varieties of both bright stock and retail stock. There

are approximately 40-plus different flavor and size variations of bright stock in storage. The retail

stock has even more types of bars for different retail clients.

EXHIBIT 1

Salmon River Foods/Dream Chocolate Floor Plan

640 Krumwiede and Walden

Issues in Accounting Education Volume 28, No. 3, 2013

7. Shipping Area

The bars are invoiced, packed, and shipped out to the customer FOB shipping point. If deemed necessary, the bars are packed in insulated material with a cold pack to prevent melting.

PRODUCT INFORMATION

D.C. sells many types of bars, with varying sizes, ingredients, and flavors. Although there are

other sizes available, D.C. typically sells bars in three standard sizes: 1.25 oz. (both organic and

non-organic), 3.0 oz. (non-organic only), and 3.25 oz. (organic only). This section describes the

ingredients, labor, and overhead required to make its bars.

Materials

Table 1 provides typical prices and costs of chocolate for the standard-sized bars. The bulk

chocolate is generally from German suppliers, but D.C. also has a U.S. supplier of high-quality

chocolate. Chocolate prices can vary, due largely to unstable conditions in major cocoa bean-

producing nations such as the Ivory Coast. Standard chocolate bars, with no additional flavors or

special ingredients, comprise about half (47 percent) of total sales. Besides chocolate and other

ingredients, the product cost includes the foil and label. Table 1 provides the typical costs for these

items.

Bars can have one or more types of special flavors and ingredient additives, such as the recent

order from the wellness company. The additional costs for these additives are handled in different

ways. Flavor additives are a relatively small part of the overall weight of the bar, and primarily

affect the taste of the chocolate itself. Bars with higher-cost flavor additives, such as coffee and

Kava, comprise about 13 percent of sales. These ingredients are added to the pot and listed as an

ingredient with a direct cost (e.g., $8 for two pounds of coffee used in a batch). Less expensive

additives, such as flavoring oils (e.g., mint or lavender), are not included in direct costs as a little

goes a long way. These costs usually show up in overhead. Sixteen ounces of oil cost about $22,

and D.C. uses only two ounces for a batch of 1,200 1.25-oz. bars. About 16 percent of product sales

have these flavoring oils.

‘‘Stir-in’’ ingredients are a relatively larger part of the weight of the bar, are clearly noticeable in the final bar, and affect the overall taste of the bar rather than the chocolate itself. Bars with stir-in

ingredients, such as huckleberries and all nuts, comprise about 24 percent of sales and add

additional direct materials and direct labor costs. Kay estimates $12 per pound average for nuts,

TABLE 1

Typical Prices and Costs of Chocolate

1.25 oz. Bar 3.0 oz. Bar 3.25 oz. Bar

Price Per Bar � Non-Organic $1.40 $2.40 NA � Organic $1.50 NA $2.55

Cost of Chocolatea � Non-Organic $0.18 $0.44 NA � Organic $0.33 NA $0.83

Cost of Foil $0.03 $0.06 $0.06

Cost of Label $0.03 $0.08 $0.08

a Does not include additional flavors or ‘‘stir-in’’ ingredients.

Dream Chocolate Company: Choosing a Costing System 641

Issues in Accounting Education Volume 28, No. 3, 2013

ginger, and huckleberries, and these ingredients become about 5 percent of the finished weight of

the bar. In addition to the direct materials cost for these ingredients, there is additional labor

required for stirring to achieve equal distribution throughout the bar.

Direct Labor

Four of the seven production areas have labor costs that should be included in product cost.

Direct labor comes from pouring, inspecting, foiling, and labeling. Table 2 provides the average

labor rates (including benefits) and estimated average number of bars that can be processed in each

of the four labor areas. Notice that larger bars can be inspected twice as fast as the smaller bars. The

reason is that larger bars have fewer defects, so less time is needed. Because each area might be

working on multiple customer jobs at a time, it is difficult to track labor hours for each customer

order.

The extra labor cost for ‘‘stir in’’ ingredients is handled in one of two ways. If performed by the Master Chocolatier, whose salary is included in plant overhead cost, Kay considers it as no

additional direct cost. If the Master Chocolatier is busy and other workers will be required, Kay

adds $12.50/hour of labor to each stir-in batch when estimating the cost of a job.

Overhead Costs

Overhead costs include administrative costs, supplies, three salaried employees (including

Kay, Kathleen, and the Master Chocolatier), an hourly wage customer service person, and lease

payments for the building. Table 3 provides a breakdown of budgeted overhead costs per month of

$19,800, on average. Note that each production area incurs costs for supplies each month.

Capacity and Output

Currently, the factory can pour up to about 300 pounds of 1.25-oz. chocolate bars per eight-

hour day. Different bar sizes can be produced in the same batch. However, as is usually the case,

total factory output is constrained by bottleneck processes, number of qualified workers, and

customer demand. Current budgeted production is 25,000 1.25-oz. bars and 1,000 3.0/3.25-oz. bars

per month, with an estimated average order size of 200 bars. Typically, two-thirds of production is

for organic bars. Kay tries to batch all the non-organic batches together and only switch from

organic to non-organic once a month (there is no difference in setup time between the two types).

There are typically two days of production in work-in-process between the pouring and foiling

areas because that is how long it takes to make and foil the bars.

Kay is optimistic that D.C. can produce the additional 20,000 to 25,000 bars per month needed

for the big special order, but he will need additional equipment and trained workers. He will also

TABLE 2

Average Labor Rates and Capacity Volumes by Labor Area

Area Labor Rate/Houra 1.25 oz. Bar 3.0 oz. Bar 3.25 oz. Bar

Pouring $15.40 480 bars/hour 200 bars/hour 184 bars/hour

Inspecting $11.00 240 bars/hour 480 bars/hour 480 bars/hour

Foiling $9.90 175 bars/hour 175 bars/hour 175 bars/hour

Labeling $9.90 175 bars/hour 175 bars/hour 175 bars/hour

a Includes payroll taxes and benefits.

642 Krumwiede and Walden

Issues in Accounting Education Volume 28, No. 3, 2013

need to add an extra shift, but he must train additional workers first. Training can take up to two

months to be able to meet D.C.’s high standard of quality.

Kay’s Cost Estimates

Table 4 shows how Kay estimates the cost of standard types of bars. When Kay estimates costs

to price a typical order, he adds materials (including ingredients, foil, and label), direct labor, and

overhead costs per bar to get the total estimated cost per bar. For overhead, he allocates $0.69 per

bar based on producing at the bottleneck rate and assuming an average of 20.5 work days per

month, one eight-hour shift per day, and one worker per labor area. Markup percentages vary and

are affected by the size of the order and demand. When customers want a significant discount from

the normal price, he will usually decline unless there is a good chance of future business. He

accepted the big order because of the high volume and prospect for more large orders.

ACTION ITEMS

Now put yourself in Kay Johnson’s shoes and think about what type of costing approach will

help you determine more accurate products costs for pricing different orders, like the recent big

order. In Part A, you will analyze D.C.’s situation, identify its information needs, evaluate the pros

and cons of different costing approaches, recommend an approach, and suggest ways to implement

it. If your instructor assigns Part B, you will calculate product costs based on your recommended

approach.

Part A: Choosing a Costing System

A1: What Information Does D.C. Need?

Before recommending a cost system, it is helpful to understand the cost information needs of

the company. Based on case information, briefly summarize D.C.’s competitive environment and its

apparent strategy in response to that environment. Considering the company’s strategy and

products, what types of cost information should D.C.’s product costing system be able to provide?

A2: Which Costing Approach(es) Do You Recommend?

a: Discuss the pros and cons of the different costing approaches available to D.C., including

job order costing, process costing, operation costing, and activity-based costing.

TABLE 3

Budgeted Monthly Overhead Cost Breakdown

Cost Item Amount

Admin. Costs $1,000

Production Area Supplies 3,800

Salaries 10,000

Customer Service 3,000

Lease Payments 2,000

Total Budgeted Overhead Costs $19,800

Dream Chocolate Company: Choosing a Costing System 643

Issues in Accounting Education Volume 28, No. 3, 2013

TABLE 4

How Kay Estimates Cost and Profitability Per Bar

Panel A: Compute Estimated Materials Costs Per Bar

Material 1.25 oz. 3.0 oz. 3.25 oz.

Non-Organic Chocolate $0.18 $0.44 NA

Organic Chocolate 0.33 NA $0.83

Foil 0.03 0.06 $0.06

Label 0.03 0.08 $0.08

Total Non-Organic $0.24 $0.58 NA

Total Organic $0.39 NA $0.97

There would be additional costs for certain flavor additives.

Panel B: Compute Estimated Labor Costs Per Bar (Labor Rate 4 Bars Per Hour from Table 2)

Labor Area 1.25 oz. 3.0 oz. 3.25 oz.

Pouring Area $0.03 $0.08 $0.08

Inspection Area 0.05 0.02 0.02

Foiling Area 0.06 0.06 0.06

Labeling Area 0.06 0.06 0.06

Total Labor Cost Per Bar $0.20 $0.22 $0.22

Panel C: Compute Estimated Overhead Cost Per Bar