2) Problems Faced By Managers can be summarised as follows: Initially Classic pen Company used to sell only two products consisting of Blue and Black coloured pens but recently observing the opportunities and scenario it has been proposed to expand the companies production by introducing new colours RED and PURPLE being the most recent inclusions.they are also hoping of including some more new colours in the near future.But Dempsey faced great disappointments when he observed the year end financial reports because the new products didn’t seem to earn more profit margin than their original product consisting of Blue and Black coloured pen.Hence the overall profit has gone down .Red coloured pens were sold at a premium premium of 3% and Purple coloured pens were sold at a premium of 10%.profit margins on Blue and Black coloured pens were 20%.So Dempsey who is the controller of the Classic Pen Conpany is investigating what went wrong because of which they didn’t get the desired results.The various problems faced by the company can be summarised as under: •
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Firstly their recently introduced products in the form of Red and Purple coloured pens are not earning expected profit margins. Their overall profit has declined. They are in a dilemma whether to introduce some more range of new products because customers are willing to pay more for the speciality coloured pens. Some of the operational problems arised due to introduction of Red coloured pens which required more changeovers from the existing process.Five years ago it was a lot simpler but now the process has become a lot more complicated because new Purple and Red pens have a demanding specifications , Red being more demanding. They tend to spend a lot of time on purchasing and scheduling activities and just keeping track of where they stood on existing , backlogged and future orders. A routing sheet identified the sequence of operations required for each operating step.This information was used to calculate the labour expenses for each operating step.All plants indirect expenses were aggregated at the plant level and allocated to products based on their direct labour content.Currently the overhead burden rate was 300% of of the direct labour cost while it was 200% just few years back.
The above mentioned problems are important specially because company wants to introduce some new range of products so without knowing the causes of current problems it would not be healthy to go ahead with new introductions.Also they need to know why the new products are giving less profit margins than the old products.As competition intensifies , companies are increasingly producing greater variety of products and services.Using broad averages to uniformly
spread the cost of resources across different products results in inaccurate and misleading product costs.one of the causes for low profit margin could be one of the primitive methods like broad averaging methods used to allocate costs.This method of cost allocating results in greater inaccuracy of product costs.for example the use of a single plantwide manufacturing overhead rate to allocate costs to products often produces unreliable cost data.In the above case too all plant indirect expenses were aggregated at the plant level and allocated to products based on their direct labour content.Hence this led to overhead direct burden of 300% a 100% increase from what it was initially(before introduction of new products).
3) An approach for soving the problem. According to the given case the controller of the company attends a seminar in which Activity –based costing was discussed . He wants to implement this system of costing because this concept seemed to address many problems faced by the company.Now we discuss about the Activity based costing. Activity – based costing is the best tools for refining costing system.Activity based costing refines a costing system by identifying individual activities as the fundamental cost objects.An activity is an event , task, or unit of work with a specified purpose-for example designing products , setting up machines, operating machines, and distributing products.ABC systems calculate the costs of individual activities and assign costs to cost objects such as products and services on the basis of the activities needed to produce each product or service For many years, construction firms and industry trade groups have collected cost data from a multitude of different construction projects. The amount of work associated with that cost was also collected with the cost data. For example, collected data included the cost of the paint, labor, equipment, and overhead to paint a room, the amount of surface area painted, and the manpower required to paint the room. This practice allowed construction professionals to obtain a cost per area and manpower per area. These costs are based on an activity, such as painting, and are known as ABC. ABCs are discussed in detail in the following sections.
A. Activity Based Costing Definition
ABC can be roughly defined by the following equation: C/A = HD + M + E + S where C/A = Estimated cost per activity H = Number of labor hours required to perform the activity one time D = Wages per labor hour M = Material costs required to perform the activity one time
E = Equipment costs to perform the activity one time S = Subcontracting costs to perform the activity one time
The total cost for performing the activity will be based on the number of times the activity is performed during a specific time frame. Cost estimators have assembled large databases of activity based cost information.
Finally the ABC method can be done in the steps as follows: •
identification of significant activities
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accumulation of activity costs
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selection of a relevant cost driver
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estimation of a driver rate
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final allocation or assignment
The basic cost drivers in modern manufacturing environment are: •
number of set-upsk..
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number of engineering change-orders
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number of customer orders
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number of non standard parts used
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number of invoices processes
Learning from the suggested reading:
ABC methodology is used when a project can be divided into defined activities. These activities are at the lowest function level of a project at which costs are tracked and performance is evaluated. Depending on the project organization, the activity may coincide with an element of the work breakdown structure (WBS) or may combine one or more elements of the WBS. However, the activities must be defined so
there is no overlap between them. After the activity is defined, the unit of work is established. All costs for the activity are estimated using the unit of work. The estimates for the units of work can be done by performing detailed estimates, using cost estimating relationships, obtaining outside quotes for equipment, etc. All costs including overhead, profit, and markups should be included in the activity cost.
Here in the given case Dempsey identifies six categories of support expenses that were currently being allocated to pen production. •
Indirect Labour costing $20000
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Fringe Benefits costing $16000
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Computer system costing $10000
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Machinery costing $8000
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Maintenance costing $4000
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Energy costing $ 2000
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Total cost $ 60000
