CLASSIC PEN COMPANY

DEVELOPING AN ABC MODEL

GROUP 10 (SECTION D)
ARIJIT NAYAK

15P189

CHANDRIMA DHAR

15P194

MIHIR UPASANI

15P212

NIDIHIN G THOMAS

15P215

SAMBIT DASH

15P225

SHIVI SHARMA

15P230

VIVEK AGGARWAL

15P240

Case Background
Originally, Company was a low-cost producer of tradition
al Blue and Black pens
Profit margins were over 20% of sales
Five years earlier Red pens were introduced at 3% premi
um
Recently Purple pens were introduced using same technol
ogy at 10% premium
Company only has one factory where all production is car
ried out

Issues faced by Management

Issue 1 Profitability

While Red and Purple pens seem to be more profita

ble, overall profitability of the company is falling

Issue 2 - Pricing

Can the products be priced better

Issue 3 Production Process

Process for Red and Purple pens requires more setup time

Issue 4 Internal Processes

A lot of time spent on scheduling and purchasing a

ctivities

Costing system of Classic Pen

All indirect costs were aggregated at plant level
and allocated to products based upon the direct
labor cost
The current overhead rate is 300% of direct lab
or cost
Before Red and Purple pens were introduced, th
e overhead rate was only 200% of direct labor c
ost

Traditional Costing Method

Classic Pen Company
Traditional Income Statement

Blue
Black
Red
Purple
Total
$
$
$
$
$
Sales
75,000.0 60,000.0 13,950.0
150,600.0
1,650.00
0
0
0
0
$
$
$
$
$
Direct Material
25,000.00 20,000.00 4,680.00 550.00
50,230.00
$
$
$
$
$
Direct Labor
10,000.00 8,000.00 1,800.00 200.00
20,000.00
Overhead (@ 300% of Direct $
$
$
$
$
labor)
30,000.00 24,000.00 5,400.00 600.00
60,000.00
$
$
$
$
$
Total Costs
65,000.00 52,000.00 11,880.00 1,350.00 130,230.00
$
$
$
$
$
Operating income
10,000.0
8,000.00 2,070.00 300.00 20,370.00
0
Return on Sales

13.33% 13.33% 14.84%

18.18
% 13.53%

Activity Based Costing

Before:
Production primarily manual
Classic Pens two products were identical with respect to volu
me and batch size

Direct labor cost and indirect labor cost has decreased

due to automation
As low volume products were introduced the result wa
s increased demand for:

Increased planning
More setups of machines
More quality control
Computers to keep track of jobs and product specifications

Activity Based Costing

Same physical output, same cost of direct material
The firm has much higher indirect and support cost
s due to the larger and more diversified product mi
x and more complex production
One unit of the high volume standard product (blu
e or black) uses approximately the same amount of
direct labor as one unit of red or purple
The use of indirect and support activities by the spe
cial products are higher that the use by the standar
d products

Activity Based Costing

Indirect labor
50% of the indirect labor costs are caused by Handl
ing Production runs
40% of the indirect labor cost were caused by the
physical change from one color to another called M
achine Setup costs
10% of the indirect labor was used to an activity Pa
rts Administration (Record keeping)
Computer Expenses
20% allocated to keep records (Parts administratio
n)
80% of computer resources were used to produce
batches and are closely related to Handling product
ion runs

Activity Based Costing

Three categories of indirect cost remained:
Machine Depreciation
Machine Maintenance
Energy
These costs were incurred for production of pens and
were a function of the machine hours taken to produc
e the pens (Running of Machines)
Fringe Benefits were 40% of both direct and indirect l
abor expenses, and were to be applied as a percentag
e markup to both

Activities and Cost Drivers

Indirect labour; Fringe Benefits; Computer Systems;
Expens Machinery; Maintenance; Energy
es
Indirect labour; Computer System Expenses; Machine
Cost
Expenses
Pool
Machine set up; Production run; Parts Administration
Activitie (Record keeping); Machine Support
s
Product Black; Blue; Red; Purple
s

Assigning Resources to Activities

Activity

Cost

Machine
Handling Set Up for
Parts
production changeov Administrati Running of
Total
runs
er
on
machines Total Expense

Indirect Labor

50%

40%

10%

$
100% 20,000.0
0

Fringe benefits
(40% of Indirect
Labor)

50%

40%

10%

100% 8,000.00

Computer
Systems
Machine
Depreciation
Machine
Maintenance
Energy

$
100% 10,000.0
0
$
100% 8,000.00

80%

20%

100%

100%

100% 4,000.00

100%

100% 2,000.00

$
Activity Expense $ 22,000.00 11,200.00 $ 4,800.00

$
14,000.00

$
$

$
52,000.0
0

Activity Cost Drivers Rate

Activity
Cost Driver
Cost Driver
Quantity
Activity Cost
Driver Rate

Cost Driver
Production
Runs
Set up time
Products
Machine
Hours

Machine
Handling
Set Up for
Parts
production changeove Administratio Running of
runs
r
n
machines
Production
No. of
Machine
runs
Setup Time products
Hours
150

526

10000

$ 146.67

$ 21.29

$ 1,200.00

$ 1.40

Activity Cost
Driver Rate

Blue

Black

Red

Purple

50

50

38

12

$ 146.67

200
1

50
1

228
1

48
1

$ 21.29
$ 1,200.00

5000

4000

900

100

$ 1.40

ABC Income statement

Classic Pen Company
ABC Based Income Statement

Blue

$
75,000.00
$
Direct Material
25,000.00
$
Direct Labor
10,000.00
Fringe Benefits (Direct $
Labor portion)
4,000.00
Handling Production
$
Runs
7,333.33
Machine Set up for
$
changeover
4,258.56
$
Parts Administration
1,200.00
$
Running of Machines 7,000.00
$
Total Costs
58,791.89
Sales

Black
$
60,000.00
$
20,000.00
$
8,000.00
$
3,200.00
$
7,333.33
$
1,064.64
$
1,200.00
$
5,600.00
$
46,397.97

Red
$
13,950.00
$
4,680.00
$
1,800.00
$
720.00
$
5,573.33
$
4,854.75
$
1,200.00
$
1,260.00
$
20,088.09

Purple
$
1,650.00
$
550.00
$
200.00
$
80.00
$
1,760.00
$
1,022.05
$
1,200.00
$
140.00
$
4,952.05

Total
$
150,600.00
$
50,230.00
$
20,000.00
$
8,000.00
$
22,000.00
$
11,200.00
$
4,800.00
$
14,000.00
$
130,230.00

Cost per unit vs. Selling Price per unit

ABC Cost per
Unit
Traditional Cost
per Unit
Selling Price

Blue

$
1.18
$
1.30
$
1.50

Black

$
1.16
$
1.30
$
1.50

Red

$
2.23
$
1.32
$
1.55

Purple

$
4.95
$
1.35
$
1.65

Observations
Return on sale varies based on the traditional costing
method and ABC method

Red color pens are sold at price less than its cost as per
ABC

Purple color pens are sold at much less price than its
cost

Company is making loss in selling Red and Purple color

pens as the
overhead cost is high

Overheads increased significantly with new products as

company has added large quantity of overheads:
computer systems and support expenses

Recommendations based on ABC analysis

Increase the sales price of red and purple pens
Improve processes to reduce setup times, especi
ally for Red pens
Look for new product designs and efficient met
hods of preparing and mixing inks