Question

Classic Pen Company: Developing an ABC Model

The Classic Pen Company Case

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 traditional BLUE and BLACK pens. Five years earlier RED pens had been introduced, which 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 10% 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 seen 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' 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 Classic Pen:

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

Professor Robert S. Kaplan prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.

Classic Pen Company: Developing an ABC Model 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.

Operations

Classic produced pens in a single factory. The major task was preparing and mixing the ink for the different colored pens. The ink was inserted into the pens in a semiautomated 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 operating step. This 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 their direct labor content. Currently this overhead burden rate was 300% 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 had 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 Classic. The speaker had even used an example that seemed to capture Classic's situation exactly.

The professor had 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…………………………………….. $20,000

Fringe Benefits……………………………………. 16,000

Computer Systems……………………………… 10,000

Machinery…………………………………………… 8,000

Maintenance………………………………………. 4,000

Energy ………………………………………………….2,000

Total…………………………………………………… $60,000

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 half of indirect labor was involved in scheduling or handling production runs. This included scheduling production orders, purchasing, preparing, and releasing materials for the production run, first-item inspection performed 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 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 10% 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 Classic'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 $10,000 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.

Since 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 80% of the computer resource was involved in the production run activity. Almost all of the remaining computer expense (20%) 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 capability of 10,000 hours of productive time that could be supplied to pen production.

Dempsey believed she now had the information to estimate an activity-based cost model for Classic Pen.

Exhibit 1 Traditional Income Statement

                                      Blue           Black          Red          Purple       Total

Sales                          $ 75,000 $ 60,00      $13,950   $1,650    $150,600

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

Direct Labor             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         13.6%        13.3%         14.8%        18.2%        13.5%

Exhibit 2 Direct Costs and Activity Cost Drivers

                                                     Blue            Black               Red           Purple         Total

Production Sales Volume        50,000         40,000            9,000        1,000        100,000

Unit Selling Price                        $1.50          $1.50             $1.55    $1.65

Materials-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                      0.1                0.1                  0.1              0.1             10,000

Production runs                        50                  50                 38               12                150

Setup time/run                           4                    1                   6                  4                                

Total setup time                      200                 50                 228             48                526

Parts Administration           1                   1                  1               1                 4

Discuss the Exhibit 1 financial results in light of the insights provided by an activity-based analysis of Classic Pen’s operations, and recommend specific management action in response to the insights.

Answer 1

Income statement as per ABC allocation of Ohs
	Blue	Black	Red	Purple	Total	OH allocation basis
1..Sales	75000	60000	13950	1650	150600
Less:
a.Material costs	25000	20000	4680	550	50230
b.Direct Labor	10000	8000	1800	200	20000
c.Indirect Labor	3333	3333	2533	800	10000	prodn.runs	50:50:38:12
	3042	760	3468	730	8000	Tot.Set-uptime	200:50:228:48
	500	500	500	500	2000	Parts admn.	1:1:1:1:1
Total c.	6875	4594	6501	2030	20000
d.Fringe benefits
40%*(b+c)	6750	5038	3320	892	16000
e.Computer systems	2667	2667	2027	640	8000	prodn.runs	50:50:38:12
	500	500	500	500	2000	Parts admn.	1:1:1:1:1
Total e.	3167	3167	2527	1140	10000
f.Machine depreciation	4000	3200	720	80	8000	Total M/c hrs.	50:40:9:1
g.Machine maintenance	2000	1600	360	40	4000	Total M/c hrs.	50:40:9:1
h. Energy	1000	800	180	20	2000	Total M/c hrs.	50:40:9:1
i.Total Ohs as per ABC allocation
(c+d+e+f+g+h)	23792	18398	13608	4202	60000
2..Total costs
a+b+i	58792	46398	20088	4952	130230
3..Net operating Income
(1-2)	16208	13602	-6138	-3302	20370
Profit Margin
(3/1)	21.61%	22.67%	-44.00%	-200.12%	13.53%

Traditional OH allocation	30000	24000	5400	600	60000
OH as per ABC allocation	23792	18398	13608	4202	60000
Difference	6208	5602	-8208	-3602	0
% variation	20.69%	23.34%	-152.00%	-600.34%	0

From the above, allocation of Ohs according to activities performed ,rather than as a flat % on labor costs , shows that Purple line followed by the Red line contributes to more Ohs costs --thus being the reason for greater negative profit margin --also in that order---purple , followed by red.

So, both the purple & red lines are unprofitable, reason for bringing down the profit margin