Comprehensive Product Costing

Financial Information 

The following data shows financial information of the Chipotle Mexican Grill. The data presented is fictitious for the sake of calculation and therefore, do not represent actual financial information of Chipotle Mexican Grill. During 2017 financial year, Chipotle produced and sold 1, 500,000 Romaine Lettuce, 1,500, 000 Guacamole, and 1, 500, 000 Crispy Corn Tacos. 

Product	Romaine Lettuce	Guacamole	Crispy Corn Tacos
Units produced  And sold	1500000	1500000	1500000
Selling price/unit	$4	$2	$3
Direct labor cost/unit	$0.5	$0.5	$0.75
Direct material cost/  Unit	$0.75	$0.5	$0.5

Indirect costs for all three products

.Indirect Components	Costs
Material Purchasing	$600,000
Equipment Setups	$750000
Product packaging	$700000
Equipment testing	$850000
Equipment maintenance	$800000
Total	$3700000

Activity Pool	Cost Driver  Activity Units	Cost Driver  Unit Costs	Total activity  Romaine Lettuce	Total activity  Guacamole	Total Activity  Tacos
Material purchasing	Number of purchase orders	$1500	200	150	250
Equipment setups	Number of setups	$1200	400	300	350
Product packaging	Number of product packages  Packed	$0.20	1000000	800000	750000
Equipment testing	Number of tests	$100	3500	2000	2500
Equipment maintenance	Number of batch runs	$1200	500	300	400

Computations 

Direct Cost (Traditional Method) 

Direct costs are prices that directly contribute to the production of a specific good ( Husted et al., 2018 ). These costs may include direct labor cost or direct raw material cost. For example, if an employee is hired to perform a task, the expenses paid for their labor is direct cost. Direct costs are also known as variable costs. 

Total direct cost = direct material cost + direct labor costs 

Product	Romaine LETTUCE	Guacamole	Tacos	Total
Units Sold	1500000	1500000	1500000
Selling Price/unit	4	2	3
Direct labor cost/unit	0.5	0.5	0.75
Direct material cost/unit	0.75	0.5	0.5
Sales Revenue	6000000	3000000	4500000	13500000
Direct labor cost	750000	750000	1125000	2625000
Direct material cost	1125000	750000	750000	2625000
Total direct cost	1875000	1500000	1875000	5250000

Indirect Costs 

Indirect costs are expenses that are not directly attributable to a production of a certain good. These costs may include rent, management, and maintenance ( Huang, 2018 ). These costs are also known as fixed costs. The total indirect costs is $3,700,000 while the total direct cost of is 5250000. The ration of indirect costs: direct cost is 3700000/5250000 = 0.7048. Therefore, indirect costs are 0.7048 times direct costs. 

Indirect costs for Romaine Lettuce = 0.7048 * Its direct cost 

= 0.7048*18755000 

= 1321429 

Indirect cost for Guacamole = 0.7048 * 1500000 

= 1057142 

Indirect cost for Tacos = 0.7048 * 1875000 

= 1321429 

Net Profit under Traditional Costing Methods 

Net profit is the difference between sales revenue and the total cost of production ( Monroy et al., 2014 ). 

Total cost of production = direct costs + indirect costs 

Product	Romaine LETTUCE	Guacamole	Tacos
Units Produced and sold	1500000	1500000	1500000
Total direct cost	1875000	1500000	1875000
Total indirect cost	1321429	1057142	1321429
Revenue per unit	4	2	3
Direct cost per unit	1.25	1	1.25
Indirect cost per unit	0.880952667	0.704761333	0.880953
Net profit per unit	1.869047333	0.295238667	0.869047
Net profit margin per unit	0.467261833	0.147619333	0.289682

Activity Based Costing 

Direct Costs 

Direct costs under activity based method are the same as direct costs under traditional methods. 

Product	Romaine LETTUCE	Guacamole	Tacos	Total
Units Sold	1500000	1500000	1500000
Selling Price/unit	4	2	3
Direct labor cost/unit	0.5	0.5	0.75
Direct material cost/unit	0.75	0.5	0.5
Sales Revenue	6000000	3000000	4500000	13500000
Direct labor cost	750000	750000	1125000	2625000
Direct material cost	1125000	750000	750000	2625000
Total direct cost	1875000	1500000	1875000	5250000

Overhead Costs/ Indirect Costs per unit 

In the below table, A is the Romaine Lettuce, B is Guacamole, and C is Crispy Corn Tacos. 

Activity pool	Cost Driver	Cost Driver Units Cost	Total activity A	Total activity B	Total activity C	Total cost A	Total cost B	Total cost C	Cost per unit A	Cost per unit B	Cost per unit C	Total Indirect costs
Material Purchasing	Number of purchase orders	1500	200	150	250	300000	225000	375000	0.2	0.15	0.25	900000
Equipment setups	Number of set ups	1200	400	300	350	480000	360000	420000	0.32	0.24	0.28	1260000
Product packaging	Number of packages packed	0.2	1000000	800000	750000	200000	160000	150000	0.133333333	0.106666667	0.1	510000
Equipment testing	Number of tests	100	3500	2000	2500	350000	200000	250000	0.233333333	0.133333333	0.166666667	800000
Equipment maintenance	Number of batch runs	1200	500	300	400	600000	360000	480000	0.4	0.24	0.32	1440000
	Total					1930000	1305000	1675000	1.286666667	0.87	1.116666667	4910000

Net Profit under ABC

Product	Lettuce	Guacamole	Tacos
Units produced and sold	1500000	1500000	1500000
Total direct costs	1875000	1500000	1875000
Total overhead costs	1930000	1305000	1675000
Revenues per unit	4	2	3
Direct costs per unit	1.25	1	1.25
Overhead cost per unit	1.28666667	0.87	1.1166667
Net profit per unit	1.46333333	0.13	0.6333333
Net profit margin	0.36583333	0.065	0.2111111

Product profitability	Lettuce	Guacamole	Tacos
Traditional cost allocation	46.7%	14.7%	29%
Activity based costing approach	36.6%	6.5%	21.1%

MEMORANDUM 

TO: CEO CHIPOTLE MEXICAN GRILL 

FROM: JOHN SMITH 

CC: PRODUCTION MANAGER CHIPOTLE MEXICAN GRILL 

DATE: 18/07/2018 

SUBJECT: COSTING METHOD 

Product Costing Methods 

Product costing method in any manufacturing industry, such as food manufacturing industry like restaurants, are financial techniques that are used for better understanding of the value of inputs and what such inputs produces in the production process. Product costing method enables the corporate management to track and categorize information regarding the value of input and outputs. This makes it possible for corporate management to determine key industry performance indicators such as cost per unit production with a high degree of accuracy ( Huang , 2018) . Such information is also essential for the sake of making important decisions such as product pricing, future investments, competitive strategies, production levels, among others. The management also requires such information for effective internal management. 

The basics of costing methods include fixed costs, variable costs, direct costs, and indirect costs. Fixed costs are those costs that are not affected by changes in production. Such costs would accrue even in a situation where there is no production. Fixed costs include rent, taxes on property owned, salaries of the executive, and interest payments. The idea of a fixed cost is only relevant within a certain time frame. This is because, after some time such costs might vary. For instance, in a situation where the company decides to expand its production due to increased product demands, the firm will have to adopt higher level expenditure leading to more expenditure on rent, equipment, property taxes, among others. On the other hand, variable costs change with respect to the level of output. Such costs include the cost of materials used in the production process. Increase in output level will require a proportionate increase in the cost of materials used and vice versa. Direct costs/prime costs are costs which are easily traceable to the object to be evaluated ( Huang , 2018) . These costs are directly required to produce a certain good. They can be either direct labor cost or direct material costs. Indirect costs, on the other hand, are not readily traceable to the costed object. 

Traditional Costing Vs Activity-Based Costing 

Product costing methods are categorized into traditional costing methods and activity-based costing method. Traditional costing method includes process and job-order costing. Process costing involves analysis of the net cost accrued during the manufacturing process, say production of tacos, over a specified period of time. The unit cost of producing tacos for sale is found by dividing the net costs accrued while producing tacos by the total units of tacos produced for sale ( Huang , 2018) . Due to the various processes involved in the production process, a unit cost is determined for each step, and an average unit cost is determined for the entire production process. On the other hand, in job-order costing, all costs are tracked on an individual product basis. This costing method is only applicable to a situation where there are a few products produced or where each product unit is customized. Job- order costing doesn’t require averaging of the cost incurred per unit since each unit might be different ( Husted et al., 2018) . Traditional costing method allocates factory overhead to products with respect size of production resources consumed. 

The main problem with traditional costing method is that factory overhead might exceed the basis of allocation. Due to this, a slight change in the volume of resources used could result in a massive change in overhead applied. For example, suppose in a restaurant overhead should be charged at the rate of $ 10 per direct labor hour, if there is a small change in manufacturing process increases the direct labor by one hour, the cost of the product will also increase by $10 of overhead ( Husted et al., 2018) . Such nonsensical large changes in applied overhead are realized due to the fact that there is no direct relationship between factory overhead and volume of production resources. Because of this issue with traditional costing, activity-based costing was developed ( Huang , 2018) . Activity-based costing was meant to circumvent this problem through application of in-depth analysis of the relationship between overhead costs and cost drivers. Most cost drivers are essential in the creation of a more reasonable allocation of overhead costs. However, traditional costing is still relevant for financial statements reporting where the application of overhead to the size of units produced is intended for valuing ending inventory. This does not affect the management decision-making perspective. 

Activity-based costing (ABC) is a complementary method to the traditional costing method. ABC involves analyses of the activities, gathering all costs, tracing costs to the activities, setting up output measures, and analysis of the costs. Under this costing method, activities considered as events that are cost drivers. Examples of cost drivers include purchase orders, the power consumed, maintenance requests, and machine setups. Cost drivers can be categorized into two classes that is transaction drivers and duration drivers. Transaction drivers involve how many times an activity occurs while duration drivers are used to measure the duration an activity will take to complete ( Huang , 2018) . ABC method is characterized by five broad levels of activities which are not related to the size of units produced. These activities include consumer level activity, batch-level activity, product-level activity, organization sustaining activity, and unit-level activity. 

Advantages and Disadvantages of Traditional Costing 

Calculation of cost of goods sold under traditional costing is simple. Expenses are assigned according to average overhead rate. Companies can, therefore, determine rates by applying all the indirect costs equally in a common unit, like labor hours. This is simpler as compared to the alternative method. Its simplicity also means less time spent in performing calculations for traditional costing as well as less expenditure on expensive systems for tracking expenses hence it is cost-effective. Traditional costing method is preferable by many companies because it is widely understood internally hence remains effective in situations where overhead costs are lower as compared to direct costs. Moreover, traditional costing is easy to explain externally and therefore most preferred to be used in financial statements. 

Although simple and cost-effective, traditional costing method may be less preferred due to some limitations. Limited accuracy regarding calculation of overheads has led to traditional costing being shunned by most businesses ( Monroy et al., 2014) . Calculation under this method has led to the distortion of actual overhead expenses. By not considering each activity for a specific product and instead, assigning costs arbitrarily, traditional costing skews essential measures such as product’s profitability ( Huang , 2018) . Traditional costing is also not helpful in waste reduction since it does not show the very indirect cost for each product. Traditional costing method is also too simple for today’s businesses. 

Advantages and Disadvantages of Activity Based Costing 

Activity-based costing provides a more accurate method of cost calculation, hence more reasonable pricing decisions. This method also increases the comprehensive understanding of cost drivers and overheads. This enables businesses to identify costly and non –value adding activities, helping them minimize wastes. ABC is suitable for today’s complicated businesses as it enhances product and customer profitability analysis. However, ABC may be complex to implement; implementing this system may also be costly as it involves training of accountants to adapt to this complex method. In addition, using ABC in financial statements may pose a challenge in understanding the inventory. 

Preferred Costing Method 

Although Activity-Based Costing may be complex and costly as compared to traditional costing, it offers much more benefits that cover for its costs. Activity-based costing requires a comprehensive knowledge of resources and activities that are involved in indirect support work while in traditional cost accounting, only total indirect cost and a simple allocation rule is required. Under ABC, it is possible to distribute individual overhead components differently for different products. One product may require relatively more maintenance resources compared to others which might require relatively fewer maintenance resources. Some products may also require more resources for machine set up. On the other hand, traditional cost accounting puts overhead components in fewer categories or even uses a single allocation rate for all products. Overhead costs under activity-based costing are treated as direct costs whereby the cost estimates reflect actual cost driver usage for each product hence enables apportioning of individual product units. 

In addition, net profit calculated under activity-based costing is more accurate as it reflects the true cost of production of the products as compared to net profit under traditional costing approach. Activity-based costing is therefore superior to traditional costing approach in terms of identifying genuinely profitable and unprofitable products, identifying and eliminating unnecessary expenses, distinguishing between value-added and non-value added activities, and pricing products to attain acceptable margins. As a result, activity-based costing can be used by the organization in budgeting, financial planning, human capital management, and performance measurement. Activity-based costing approach is therefore recommendable for Chipotle Mexican Grill since it identifies genuinely profitable products. 

I hope this information will be helpful regarding cost methods strategies used by your company. 

Thank you, 

Signatory: 

References

Huang, Q. I. (2018). Skylar, Inc.: Traditional Cost System vs. Activity-Based Cost System¨ CA Managerial Accounting Case Study.  Applied Finance and Accounting ,  4 (2), 55-66. 

Husted, H., Kristensen, B. B., Andreasen, S. E., Skovgaard Nielsen, C., Troelsen, A., & Gromov, K. (2018). Time-driven activity-based cost of outpatient total hip and knee arthroplasty in different set-ups.  Acta orthopaedica , 1-7. 

Monroy, C. R., Nasiri, A., & Peláez, M. Á. (2014). Activity Based Costing, Time-Driven Activity Based Costing and Lean Accounting: Differences among three accounting systems’ approach to manufacturing. In  Annals of Industrial Engineering 2012  (pp. 11-17). Springer, London.