Question

CASE MATERIALS: THE CLASSIC PEN COMPANY CASE

Case Abstract

The case is designed to help you develop an understanding of how to build an activity-based-costing model and why activity-based-costing may be more appropriate in practice than functional unit-based overhead cost allocation methods. The case requirements ask you to apply overhead and calculate product costs and gross profit using traditional plant-wide overhead allocation methods, assess the accuracy of the costing methodology given the operational environment, apply activity-based-costing concepts to recalculate the product costs and gross profit, and then effectively communicate the results of your analysis, evaluation, and recommendations in the form of a professional written memo.

Case Narrative

Jane Dempsey, controller of the Classic Pen Company, was concerned about the recent financial trends in operating results. Classic Pen had been the low-cost producer of traditional blue pens and black pens. Profit margins were over 20% of sales.

Several years earlier, Dennis Selmor, the sales manager, had seen opportunities to expand the business by extending the product line into new products that offered premium selling prices over the traditional blue and black pens. As a result, five years ago, red pens were introduced. Red pens required the same basic production technology but could be sold at a 3% premium. Last year, purple pens were introduced because of the 10% premium in selling price they could command.

Jane reviewed the financial results for the most recent year and was keenly disappointed. While the new red and purple pens seemed to be more profitable than the blue and black pens, the overall profits were down and none of the product lines were earning profits at the level that the blue and black pens had earned in the past. She is wondering if more specialty pens selling at higher margins should be introduced to boost profits.

The production manager, Jeffrey Donald, was concerned about this approach. “Five years ago, life was a lot simpler. We produced just blue and black pens in long production runs, and everything went smoothly. Difficulties started when the red pens were introduced and we had to make more changeovers. To product red pens, we have to stop production; empty the vats, clean out all remnants of the previous color, and then start production of red pens. Making black pens was easy. We didn’t even have to clean out the residual blue ink from the previous run. It was absorbed in the darker black ink. However, even small traces of either blue or black ink caused quality problems with the red pens and to a lesser extent, with the purple pens.” Jeffrey also reported that the new pens caused more time to be spent on purchasing, scheduling, and tracking.

Operations

Classic produces pens in a single factory. The major task was preparing and mixing the ink for different colored pens. The ink was inserted into the pens in a semi automated process. A final packing and shipping stage was performed manually.

Each product had a bill of materials that identified the quantity and cost of direct materials required for the product. A routing sheet identified the sequence of operations required for each manufacturing process. The information was used to calculate the labor expenses for each of the four products. All of the plant’s indirect expenses were aggregated at the plant level and allocated to products based on direct labor cost. Labor is paid at the rate of $10 per hour.

Indirect costs were estimated as follows:

Expense	Amount
Indirect labor	20,000
Fringe benefits	16,000
Computer systems	10,000
Machinery	8,000
Maintenance	4,000
Energy	2,000
Total	60,000

Fringe benefits were 40% of direct and indirect labor.

About half of the indirect labor resulted from scheduling production runs, which includes scheduling orders, purchasing, preparing, and releasing material for each run. Approximately 40% of the indirect labor was required for the physical changeover from one color pen to another. As noted previously, the changeover from blue to black ink was relatively short (1 hour) while the changeover for the other color pens was much more extensive, particularly for red pens. The remaining 10% of indirect labor was for time spent maintaining records on the four products. This activity was essentially equal for each product.

Most of the computer expense was used to scheduling production runs in the factory and to order and pay for the materials required in each production run. Since each production run was specific to a single customer, the computer time required to prepare shipping documents and to invoice and collect from a customer was also included in this activity. In total, about 80% of the computer resource was involved in the production run activity. The remaining time was used to keep records on the four products, which was essentially equal.

The remaining three categories of overhead expenses were incurred to supply machine capacity to produce the pens. The machines had a practical capability of 10,000 hours of productive time.

Sales and production information for the four product lines is as follows:

	Blue	Black	Red	Purple
Production sales volume	50,000	40,000	9,000	1,000
Unit selling price	$1.50	$1.50	$1.55	$1.65
Material cost per unit	$0.50	$0.50	$0.52	$0.55
Direct labor per unit (hrs)	.02	.02	.02	.02
Machine hours per unit	.1	.1	.1	.1
Production runs	50	50	38	12
Setup time per run (hrs)	4	1	6	4

Case Requirements

1. Calculate a plant-wide predetermined overhead allocation rate based on direct labor cost and apply overhead to the four product lines. Calculate total product costs for the four lines using the plant-wide allocation rate and show the gross profit rate and unit cost for each.

2. What assumptions are implicit in this company’s method of allocating overhead costs to the product lines? Do you believe these assumptions are supported by the operational procedures described in this case? Discuss.

3. Identify the main activities performed in the production process. Perform a first stage cost allocation and calculate allocation rates for each activity. Comment on your results with respect to the current allocation method. Do you believe that the costs as currently calculated are accurate? Why or why not?

4. Determine the estimated cost of each product line using activity-based-costing and the gross profit rate for each. What can you conclude about the cost accuracy of the two methods? Were costs distorted using a single allocation rate method?

5. As a result of the new cost information calculated, what actions can management take to make this company more profitable? Be explicit.

[1] This case is an adaptation of a Harvard Business School Case 9/17/98.

Answer 1

Exhibit 1: Plant wide overhead cost allocation based on various activities

Expense Category	Expense	Cost Driver	Total Cost Driver	$ / unit driver
Ind. Labor - Scheduling Runs	$10,000.00	# Runs	150	$66.67
Ind. Labor - Changeover	$8,000.00	Setup Time	526	$15.21
Ind. Labor - Records	$2,000.00	# of Products	4	$500.00
Fringe Benefits	$16,000.00	Total Labor H	Add 40% on LH
Computer Systems /Run	$8,000.00	# Runs	150	$53.33
Computer Systems - Records	$2,000.00	# Products	4	$500.00
Machinery	$8,000.00	Machine H	10000	$0.80
Maintenance	$4,000.00	Machine H	10000	$0.40
Energy	$2,000.00	Machine H	10000	$0.20
TOTAL	$60,000.00

Exhibit 2: Total overhead cost per cost driver

# Runs
	Ind. Labor - Scheduling Runs	$66.67
	40% Frings on indirect. Labor	$26.67
	Computer Systems /Run	$53.33
Total OH cost / # Runs	$146.67
Setup Time
	Ind. Labor - Changeover	$15.21
	40% Frings on indirect. Labor	$6.08
Total OH / Setup H	$21.29
Machine Hour
	Machinery	$0.80
	Maintenance	$0.40
	Energy	$0.20
Total OH / Machine Hour	$1.40
# Products
	Ind. Labor - Records	$500.00
	40% Frings on indirect. Labor	$200.00
	Computer Systems - Records	$500.00
Total OH / # Products	$1,200.00

Exhibit 3: Overhead costs allocated based on resource utilization

Exhibit 4: Revised income statement

		BLUE		BLACK		RED		PURPLE		TOTAL
Sales	$75,000		$60,000		$13,950		$1,650		$150,600
	Materials	$25,000		$20,000		$4,680		$550		$50,230
	Direct Labor	$10,000		$8,000		$1,800		$200		$20,000
Total Direct COGS	$35,000		$28,000		$6,480		$750		$70,230
Indirect OH costs	$23,792		$18,398		$13,608		$4,202		$60,000
Total Costs	$58,792		$46,398		$20,088		$4,952		$130,230
Operating Income	$16,208		$13,602		-$6,138		-$3,302		$20,370

Exhibit 5: Revenue % per pen color

	BLUE		BLACK		RED		PURPLE		TOTAL
$ Sales	$75,000		$60,000		$13,950		$1,650		$150,600
% Total Sales	50%		40%		9%		1%		100%

· Exhibit 1 shows how overhead costs related to indirect labour and computer systems have been sub-divided based on activities performed. This provides a more precise cost division than pooling these cost items into single categories. Fringe benefits have been excluded from the cost allocation and instead a 40% premium on all labour costs was included. This reduces the number of costs items and therefore simplifies the company’s understanding of cost drivers.

· Exhibit 2 demonstrates the total overhead costs per cost driver. This will provide information on cost per units of the various cost drivers.

· Exhibit 3 shows the unit product costs for each product category using ABC costing. This method charges to each product its actual consumption of indirect costs, which is more effective than allocating costs based on plant-wide averages.

· Exhibit 4 shows a revised income statement based on ABC overhead allocation. Contrary to Ms. Dempsey’s previous statement, PURPLE and RED pens actually generate operating losses.

· Exhibit 5 demonstrates the percentage revenue of each product category. PURPLE and RED pens only account for 10% of total revenues, a figure that is not that significant compared to the amount of resources they consume to produce.

· The company is making product development decisions based on inaccurate information.

· Increasing the price of PURPLE and RED pens is not a viable option for the company, as pen prices are sold based on a fixed premium driven by market.

· With total annual revenues of $150K, the company most likely cannot sustain a sales manager, a controller, a manufacturing manager, manufacturing and maintenance staff on the payroll.

· Focusing on price rather than profitability and/or revenue potential is not an effective sales strategy if the company’s goal is to maximize profits.

Since physical changeovers account for 40% of indirect labor, color diversification is costly, especially if volumes are low.

· Adopt ABC costing in order to assess the profitability of products more effectively.

· Stop taking orders for RED and PURPLE pens, and once orders are fulfilled, color productions should be discontinued.

· Make longer production runs of BLACK and BLUE to minimize physical changeovers and thereby reduce associated overheads.