CLASSIC PEN COMPANY DEVELOPING AN ABC MODEL GROUP GROUP 10 (SECT (SECTION ION D) ARIJIT NAYAK
15P189
CHANDRIMA DHAR
15P194
MIHIR UPASANI
15P212
NIDIHIN G TH THOMAS
15P215
SAMBIT DASH
15P225
SHIVI SHARMA
15P230
VIVEK AGGARWAL
15P240
Case Background •
Originally, Company was a low-cost producer of traditional Blue and Black pens
•
Profit margins were over 20% of sales
•
Five years earlier Red pens were introduced at 3% premium
•
•
Recently Purple pens were introduced using same technology at 10% premium Company only has one factory where all production is carried out
Issues faced by Management •
Issue 1 – Profitability •
While Red and Purple pens seem to be more profitable, overall profitability of the company is falling
•
Issue 2 - Pricing
•
Issue 3 – Production Process •
•
Process for Red and Purple pens requires more set-up time
Issue 4 – Internal Processes • •
A lot of time spent on scheduling and purchasing activities No capability to handle additional confusion and complexity in operations
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 labor cost Before Red and Purple pens were introduced, the overhead rate was only 200% of direct labor cost
Traditional Costing Method Classic Pen Company Traditional Income Statement Blue
Black
Red
Purple
Total
Sales
$ 75,000.00 $ 60,000.00 $ 13,950.00 $ 1,650.00 $ 150,600.00
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
$ 10,000.00 $ 8,000.00 $ 2,070.00 $
Return on Sales
13.33%
13.33%
14.84%
300.00 $ 20,370.00
18.18%
13.53%
Activity Based Costing •
Before: –
–
Production primarily manual Classic Pen’s two products were identical with respect to volume and batch size
•
automation •
As low volume products were introduced the result was 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 costs due to the larger and more diversified product mix and more complex production One unit of the high volume standard product (blue 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 special products are higher that the use by the standard products
Activity Based Costing •
Indirect labor 50% of the indirect labor costs are caused by Handling –
Production runs –
40% of the indirect labor cost were caused by the physical change from one color to another called Machine Setup costs
–
10% of the indirect labor was used to an activity Parts Administration (Record keeping)
•
Computer Expenses –
–
20% allocated to keep records (Parts administration) 80% of computer resources were used to produce batches and are closely related to Handling production runs
Activity Based Costing •
Three categories of indirect cost remained: Machine Depreciation Machine Maintenance Energy –
–
–
•
function of the machine hours taken to produce the pens (Running of Machines ) •
Fringe Benefits were 40% of both direct and indirect labor expenses, and were to be applied as a percentage markup to both
Activities and Cost Drivers • Indirect labour; Fringe Benefits; Computer Systems; Machinery; Maintenance; Energy Expenses
• Indirect labour; Computer System Expenses; Machine Expenses Cost Poo
• Machine set up; Production run; Parts Administration (Record keeping); Machine Support Activities
Products
• Black; Blue; Red; Purple
Assigning Resources to Activities Activity
Cost
Handling production runs
Indirect Labor
50%
40%
50%
40%
of Indirect Labor) Computer Systems
80%
Machine Set Up for Parts changeover Administration
Total
Total Expense
10%
100%
$ 20,000.00
10%
100%
$ 8,000.00
20%
100%
$ 10,000.00
100%
100%
$ 8,000.00
100%
100%
$ 4,000.00
100%
100%
$ 2,000.00
Machine Depreciation Machine Maintenance Energy Activity Expense
$ 22,000.00
$ 11,200.00 $ 4,800.00
Running of machines
$ 14,000.00
$ 52,000.00
Activity Cost Drivers Rate Activity
Machine Set Handling Up for Parts production runs changeover Administration
Cost Driver
Production runs Setup Time
Running of machines
No. of products Machine Hours
Cost Driver Quantity
150
526
4
10000
Activity Cost Driver Rate
$ 146.67
$ 21.29
$ 1,200.00
$ 1.40
Cost Driver
Activity Cost Driver Purple Rate
Blue
Black
Red
Production Runs
50
50
38
12
$ 146.67
Set up time
200
50
228
48
$ 21.29
1
1
1
1
$ 1,200.00
5000
4000
900
100
Products Machine Hours
$ 1.40
ABC Income statement Classic Pen Company ABC Based Income Statement Blue
Black
Red
Purple
Total
Sales
$ 75,000.00
$ 60,000.00 $ 13,950.00
$ 1,650.00 $ 150,600.00
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
Fringe Benefits (Direct Labor $ 4,000.00 portion)
$ 3,200.00 $
Handling Production Runs
$ 7,333.33
$ 7,333.33 $ 5,573.33
$ 1,760.00 $ 22,000.00
Machine Set up for changeover
$ 4,258.56
$ 1,064.64 $ 4,854.75
$ 1,022.05 $ 11,200.00
Parts Administration
$ 1,200.00
$ 1,200.00 $ 1,200.00
$ 1,200.00 $
Running of Machines
$
$
$
Total Costs
$ 58,791.89
$ 46,397.97 $ 20,088.09
Operating income
$ 16,208.11
$ 13,602.03 $ (6,138.09) $ (3,302.05) $ 20,370.00
Return on Sales
7,000.00
21.61%
5,600.00 $
22.67%
720.00 $
1,260.00
-44.00%
80.00 $
140.00 $
8,000.00
4,800.00 14,000.00
$ 4,952.05 $ 130,230.00
-200.12%
13.53%
Cost per unit vs. Selling Price per unit Blue
Black
Red
Purple
ABC Cost per Unit
$
1.18 $
1.16 $
2.23 $
4.95
Traditional Cost per Unit
$
1.30 $
1.30 $
1.32 $
1.35
Selling Price
$
1.50 $
1.50 $
1.55 $
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
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, especially for Red pens Look for new product designs and efficient methods of preparing and mixing inks
