Classic Pen Company

Case Analysis – Activity Based Cost System

Group -07
The Classic Pen Company
Introduction
 Classic Pen Company was low-cost producer of
traditional Blue and Black ink pens
 Profit margins were over 20% of sales
 As part of product diversification introduced Red and
Purple colored pens
 5 years earlier- introduced Red Pens using same
technology expected to sold at 3% premium
 A year back, introduced Purple Pens using same
technology expected to sold 10% premium
Company Operation
 The major task was preparing & mixing the ink for the
different color pens 
 The Ink was inserted into the pens in a semi automated
process 
 A final packing & shipping stage was performed manually 
 Each product had a bill of materials that identified the
quantity &  cost of direct materials required for the product 
 All the plants indirect expenses were aggregated at the
plant level & allocated to product based on their direct labour
content 
 The sequence of operations for each operating steps
were identified through routing sheet which is used to
calculate the labour expenses for each of the four products
based on the direct labour content 
Management Concern
 Red & Purple pens seem to be more profitable but
overall profitability of the company is falling
Better pricing due to global competition
To process Red and Purple pen, it requires more
resource(more setup time)
Scheduling and purchasing activities takes lot of
time
All the 4 products failed to generate expected return
Overhead burden rate 300% of the direct labour
Views From Sales Mgr,Manufacturing Mgr & Controller

DENNIS SELMOR (Sales Manager)

 Opportunities to expand the business by extending
the product line into new products that
offered premium selling price over traditional Blue &
Black
 Consumers are willing to pay higher prices for the
special colors 

JEFFRY DONALD(Manufacturing
 Making blue and black pen was simple
Manager)
 Purple pen having demanding specification nut
not as much as Red
 Concerned about the future rumors like
introducing of new colors would hamper the
operations in the company
Jane Dempsey (Controller)
 Disappointed after seen the financial results of the
company 
Wanted to put Activity based Costing( termed as ABC
here after) Approach into practice
Identified the six categories of support expenses that
were currently being allocated to pen production 
 Exhibit 1
Exhibit 1 Traditional Income Statement
  Blue Black Red Purple Total

Sales 75,000 60,000 13,950 1,650 1,50,600

Material Cost 25,000 20,000 4,680 550 50,230

Direct Labour 10,000 8,000 1,800 200 20,000

Overhead @300% 30,000 24,000 5,400 600 60,000

Total Operating
Income 10,000 8,000 2,070 300 20,370
Return on Sales 13.33% 13.33% 14.84% 18.18% 13.53%
Exhibit 2
Exhibit 2 Direct Costs and Activity Cost Drivers
  Blue Black Red Purple Total
Production Sales
Volume 50,000 40,000 9,000 1,000 1,00,000

Unit selling Price 1.50 1.50 1.55 1.65  

Materilas-unit cost 0.50 0.50 0.52 0.55  

Direct Labor hrs/unit 0.02 0.02 0.02 0.02 2,000

Machine hrs/unit 0.10 0.10 0.10 0.10 10,000

Production runs 50 50 38 12 150

Setup time/run 4 1 6 4  

Total Setup time (hrs) 200 50 228 48 526

Parts Administration 1 1 1 1 4
Assumptions While Using
ABC
Fringe benefits - 16000 (40% of direct and indirect labour)

1st Approach :
Allocating fringe benefits equally - 20% or 8000 to direct labour
and 8000 to indirect labour
So, indirect labour is treated as 20000 + 8000 (FB) = 28000

2nd Approach :
Allocating entire fringe benefits (16000) separately.
 Considering 1st Approach
Cost pool – under ABC
Indirect Labour 20,000  
40 % of direct labour 8,000  
    28,000
Computer Systems 10,000  
    10,000
Machinery 8,000  
Maintenance 4,000  
Energy 2,000  
    14,000
Total   52,000
 Cost Allocation – under ABC
Indirect Computer
  labour Exp Machine Exp Total Activity Rate
Handle
Production Run 50% 14,000 80% 8,000     22,000 150 146.7

Setup time 40% 11,200         11,200 526 21.3

Parts
Administration 10% 2,800 20% 2,000     4,800 4 1,200.0

Machine Support         100% 14,000 14,000 10,000 1.4

Total   28,000   10,000   14,000 52,000    

 Cost Sheet
  Blue Black Red Purple Total
Production Sales Volume 50,000 40,000 9,000 1,000 1,00,000
Material Cost 25,000 20,000 4,680 550 50,230
Direct Labour 10,000 8,000 1,800 200 20,000
40% Fringe Benefits 4,000 3,200 720 80 8,000
Overheads          
Machine Support 7,000 5,600 1,260 140 14,000
Prod Run Exp. 7,333 7,333 5,573 1,760 22,000
Set up Exp. 4,259 1,065 4,855 1,022 11,200
Admin Exp 1,200 1,200 1,200 1,200 4,800
Total Overheads 19,792 15,198 12,888 4,122 52,000
           
Total Cost 58,792 46,398 20,088 4,952 1,30,230
CPU 1.18 1.16 2.23 4.95 
Sales 75,000 60,000 13,950 1,650 1,50,600
  1.5 1.5 1.55 1.65 
Profit 16,208 13,602 -6,138 -3,302 20,370
Profit/unit 0.32 0.34 -0.68 -3.3 
Profit Margin 22% 23% -44% -200% 14%
Using 2 Approach
nd

* Cost of labor per hour: $10

Over Head Breakup
Traditional Costing Activity Based Costing

Return on Sales BLUE BLACK RED PURPLE TOTAL

Traditional 13.3% 13.3% 14.8% 18.2% 13.5%

ABC 21.6% 22.7% -44.0% -200.1% 13.5%

 Product Mix Simulation
Tradeoff between red and purple
Red runs Purple runs Red cost Purple cost
38 12 2.23 4.97
37 15 2.22 4.69
36 18 2.21 4.5
35 21 2.2 4.35
34 24 2.19 4.23
33 27 2.18 4.13
30 36 2.16 3.91
25 49 2.15 3.69
20 64 2.15 3.5
15 78 2.19 3.36
10 92 2.32 3.24
5 106 2.8 3.13

If you reduce the production of red pens and use the capacity to produce
purple pens this slide shows the trend of cost of purple pen.
This can be extended to find the optimal product mix.
Observations and suggestions
Return on Sales of Blue, Black, Red ,Purple pens 
are 21.6% ,22.7%,- 44.0% ,- 200.1% respectively 

Toproduce the new product the company has added large quantity of overhead such as
Computer System & Support Expenses 

The overhead to the new product are high under ABC method which is positive reflect of
cost determination 

Conclusion 1:
As Red & Purple incurring huge amount of loss hence the production should be

stopped given the current demand and plant capacity. Since we do not know the fixed cost we
cannot take a decision based on marginal cost of producing red and purple pen.
Conclusion 2:
If plans to continue all the product line the following points should be explored further

More marketing for Purple pen to increase the customer base

Changing product mix to take advantage of ‘Economy of Scale’

 Increasing the capacity in terms of no. of lines and Quantity per batch .

Increase the selling price for the Purple and Red

 THANK YOU !!!

Group 07 Team Members

• Adbul Ahad
• Ananth Rao
• Ashish Nair
• Ankit Rustagi
• Anupriya Sen
• Dushyant Singh
• Hudson Moses
• Subrahmanyam Chavali