Question

Walker Pen Company

Jane Dempsey, controller of the Walker Pen Company, was concerned about the recent financial trends in operating results. Walker Pen had been the low-cost producer of traditional BLUE pens and BLACK pens. Profit margins were over 22% 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 traditional BLUE and BLACK pens. Five years earlier, RED pens had been introduced; they required the same basic production technology but could be sold at a 3% premium. And last year, PURPLE pens had been introduced because of the 8% premium in selling price they could command.

But Dempsey had just seen the financial results (see Exhibit 1) for the most recent fiscal year and was keenly disappointed.

The new RED and PURPLE pens do seem more profitable than our BLUE and BLACK pens, but overall profitability is down, and even the new products are not earning the margins we used to see from our traditional products. Perhaps this is the tougher global competition I have been reading about. At least the new line, particularly PURPLE pens, is showing much higher margins. Perhaps we should follow Dennis's advice and introduce even more specialty colored pens. Dennis claims that consumers are willing to pay higher prices for these specialty colors.

Jeffrey Donald, the manufacturing manager, was also reflecting on the changed environment at the Walker Pen Company:

Five years ago, life was a lot simpler. We produced just BLUE and BLACK pens in long production runs, and everything ran smoothly, without much intervention. Difficulties started when the RED pens were introduced and we had to make more changeovers. This required us to stop production, empty the vats, clean out all remnants of the previous color, and then start the production of the red ink. Making black ink was simple; we didn't even have to clean out the residual blue ink from the previous run if we just dumped in enough black ink to cover it up. But for the RED pens, even small traces of the blue or black ink created quality problems. And the ink for the new PURPLE pens also has demanding specifications, but not quite as demanding as for RED pens.

We seem to be spending a lot more time on purchasing and scheduling activities and just keeping track of where we stand on existing, backlogged, and future orders. The new computer system we got last year helped a lot to reduce the confusion. But I am concerned about rumors I keep hearing that even more new colors may be introduced in the near future. I don't think we have any more capability to handle additional confusion and complexity in our operations.

Exhibit 1

Traditional Income Statement

Blue Black Red Purple Total

Sales $88,408 $64,328 $15,930 $1,674 $170,340

Material costs 29,298 21,318 5,040 468 $56,124

Direct labor 12,028 8,752 2,106 211 $23,097

Overhead @ 270% 32,476 23,630 5,686 570 $62,362

Total operating income $14,606 $10,628 $3,098 $425 $28,757

Return on sales 17% 17% 19% 25% 17%

Operations

The Walker Pen Company produces pens in a single factory. The major task is preparing and mixing the ink for the different-colored pens. The ink is inserted into the pens in a semiautomated process. A final packing and shipping stage is performed manually.

Each product has a bill of materials that identifies the quantity and cost of direct materials required for the product. A routing sheet identifies the sequence of operations required for each operating step. This information is used to calculate the labor expenses for each of the four products. All of the plant's indirect expenses are aggregated at the plant level and allocated to products on the basis of their direct labor content. Currently, this overhead burden rate is 270% of direct labor cost. Most people in the plant recalled that not too many years ago the overhead rate was only 200%.

Activity-Based Costing

Jane Dempsey recently attended a seminar of her professional organization in which a professor had talked about a new concept, called activity-based costing (ABC). This concept seemed to address many of the problems she had been seeing at the Walker Pen Company. The speaker even used an example that seemed to capture Walker's situation exactly.

The professor argued that overhead should not be viewed as a cost or a burden to be allocated on top of direct labor. Rather, the organization should focus on activities performed by the indirect and support resource of the organization and try to link the cost of performing these activities directly to the products for which they were performed. Dempsey obtained several books and articles on the subject and soon tried to put into practice the message she had heard and read about.

Activity-Based Cost Analysis

Dempsey first identified six categories of support expenses that were currently being allocated to pen production:

Expense Category Expense

Indirect labor $20,626

Fringe benefits 17,489

Computer systems 10,193

Machinery 7,396

Maintenance 4,437

Energy 2,221

Total $62,362

She determined that the fringe benefits were 40% of labor expenses (both direct and indirect) and would thus represent just a percentage markup to be applied on top of direct and indirect labor charges.

Dempsey interviewed department heads in charge of indirect labor and found that three main activities accounted for their work. About 52% of indirect labor was involved in scheduling or handling production runs. This proportion included scheduling production orders; purchasing, preparing, and releasing materials for the production run; performing a first-item inspection every time the process was changed over, and some scrap loss at the beginning of each run until the process settled down. Another 40% of indirect labor was required just for the physical changeover from one color pen to another.

The time to change over to BLACK pens was relatively short (about 1.1 hour) since the previous color did not have to be completely eliminated from the machinery. Other colors required longer changeover times; RED pens required the most extensive changeover to meet the demanding quality specification for this color.

The remaining 8% of the time was spent maintaining records on the four products, including the bill of materials and routing information, monitoring and maintaining a minimum supply of raw materials and finished goods inventory for each product, improving the production processes, and performing engineering changes for the products. Dempsey also collected information on potential activity cost drivers for Walker's activities (see Exhibit 2) and the distribution of the cost drivers for each of the four products. Dempsey next turned her attention to the $10,193 of expenses to operate the company's computer system. She interviewed the managers of the Data Center and the Management Information System departments and found that most of the computer's time (and software expense) was used to schedule production runs in the factory and to order and pay for the materials required in each production run.

Because each production run was made for a particular 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 79% of the computer resource was involved in the production run activity. Almost all of the remaining computer expense (21%) was used to keep records on the four products, including production process and associated engineering change notice information.

The remaining three categories of overhead expense (machine depreciation, machine maintenance, and the energy to operate the machines) were incurred to supply machine capacity to produce the pens. The machines had a practical capacity of 10,100 hours of productive time that could be supplied to pen production.

Dempsey believed that she now had the information she needed to estimate an activity-based cost model for the Walker Pen Company.

Exhibit 2

Direct Costs and Activity Cost Drivers

Blue Black Red Purple Total

Production sales volume

(no. of units) 51,400 37,400 9,000 900 98,700

Unit selling price $1.72 $1.72 $1.77 $1.86

Materials/unit cost $0.57 $0.57 $0.56 $0.52

Direct labor hr/unit 0.02 0.02 0.02 0.02 1,974

Machine hour/unit 0.11 0.09 0.11 0.10 10,100

No. of production runs 53 41 41 11 146

Setup time/run (hours) 4.60 1.10 6.40 3.80

Total setup time (hours) 244 45 262 42 593

Number of products 1 1 1 1 4

Required:

1. Design an Excel model to estimate the costs for the four pen products using an activity-based costing approach (provide a unit cost per pen color).

2. Prepare a revised income statement with profit margin calculations. The income statement should be modeled on Exhibit 1 and include cost by pen color and in total.

3. Write an Executive Memo to Jane Dempsey and Dennis Selmor explaining the managerial implications from the revised cost estimates.

4. Bonus Question: Why is it acceptable for the fringe benefits associated with direct to be in the overhead cost pool when using direct labor as the allocation base and it is not acceptable for the fringe benefits associated with direct labor to be in the overhead cost pool when using ABC?

Round total costs and driver amounts; use 2 decimal places for activity rates and unit costs. After allocating costs, your total overhead cost may have a rounding error of $6.

Hints:

1.) The cost of the blue pen using ABC is: $1.34 (rounded).

2.) The overhead cost pool for the ABC method totals $53,123.

3.) When switching from the plant wide allocation of overhead using direct labor as the allocation base to the ABC method, you must assign to direct labor the fringe benefits associated with direct labor and not maintain this portion of the fringe benefits in the overhead cost pool.

4.) Production is one of four activities used in the analysis.

Answer 1

1) Cost per unit using activity based model.

Particulars	Overhead	Cost Pool for Overhead	Blue	Black	Red	Purple
Material Cost			29,298	21,318	5,040	468
Direct Labour			12,028	8,752	2,106	211
Overheads
Indirect Labour(52%)	10726	Production run	3894	3012	3012	808
Indirect Labour(40%)	8250	No of products	2063	2063	2063	2063
Indirect Labour(8%)	1650	Direct labour perunit	859	625	150	15
Fringe benefit	17489	Direct labour perunit	9108	6627	1595	159
Computer System	10193	Production run	3700	2862	2862	768
Machinery	7396	Machine hour per Unit	4140	2465	725	66
Maintenance	4437	Machine hour per Unit	2484	1479	435	40
Energy	2221	Machine hour per Unit	1243	740	218	20
		Total cost	68817	49943	18206	4617
			51400	37400	9000	900
		Cost per Unit	1.34	1.34	2.02	5.13

2) Revised income statement on basis of ABC,

Particulars	Blue	Black	Red	Purple	Total
Sales	88408	64328	15930	1674	170340
Material Cost	29,298	21,318	5,040	468	56124
Direct Labour	12,028	8,752	2,106	211	23097
Overheads	27491	19873	11060	3938	62362
Total operating income	19591	14385	-2276	-2943	28757

Return on sales 22% 22% -14% -176% 17%

3) On basis of revised cost estimates we can say that red and purple pen are giving negative CM and hence they should be discontinued.