From the course: Accounting Foundations: Managerial Accounting

The real cost of ice cream

From the course: Accounting Foundations: Managerial Accounting

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The real cost of ice cream

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- All right, think about an ice cream factory. - Excellent, I love ice cream. - This particular ice cream factory makes only two flavors of ice cream, vanilla and chocolate. Okay, what kind of overhead costs are there in an ice cream factory? - Electricity, routine wear and tear on the machines, routine maintenance and cleanup. - And to keep things very simple, we're going to make only vanilla ice cream for the first six months of the year and only chocolate ice cream for the last six months of the year. During those six months, we will make extra ice cream of each flavor and store the extra ice cream to ship it during the six months we're making the other flavor. - Some of that ice cream could get a bit stale sitting there in the freezer for six months. - Agreed, so let's change the way that ice cream is made in this factory. Initially, we were going to make vanilla ice cream in one continuous batch for six months, and then switch to chocolate. Now, we're going to switch from one flavor to the other every two hours. From 8:00 am to 10:00 am each day, we'll make vanilla, From 10 to noon, we'll make chocolate, from noon to two we're going to make vanilla, and so on. Every day we'll switch. - Wow, all of this ice cream is now really fresh, but this significantly complicates the production process. - It sure does. Now, what additional overhead costs are created by this new production process where we switch flavors every two hours? - Well, we need to hire many more cleanup people. We're going to need to completely clean the machines every two hours to get the old flavor residue out so we can make the new flavor. - And what else? - We need more machine maintenance people. The machines are going to break down faster when we are stopping, resetting, and starting them so much more frequently. - Okay. What else? - Oh, we need to hire many more quality control inspectors. Now we need the inspectors testing four, five, six batches of ice cream every day to make sure we have the correct ingredient mix. - Very good. What we see in this simple example is an illustration of activity-based costing, or ABC. - ABC? - Activity-based costing. The idea behind activity-based costing is that some ways of doing business, such as producing many small ice cream batches, create overhead costs. Our product cost accounting is much more useful if we identify these overhead costs activities. - But are you saying it's bad to make the ice cream in small batches so that it's always fresh? Is it bad to customize your products to satisfy specific customer requests? It complicate your production process, creates more overhead, is that bad? - No, I'm not saying these things are bad. If your customers demand fresh ice cream or customized product, you have to respond to that. But you must also understand the additional overhead costs that these demands create. Activity-based costing, or ABC, helps you understand the business activities that create overhead costs. - Okay, it sounds like we need to learn something about ABC.

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