Case Classic Pen Company Activity Based Costing
Activity Based Costing Case Based on Classic Pen Company* with extensions Classic Pen Company: Developing an ABC Model,
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- Alee Di Vaio
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Activity Based Costing Case Based on Classic Pen Company* with extensions Classic Pen Company: Developing an ABC Model, Harvard Business School, September 17, 1998 Walnut+ Herluf Trolles Vej 243 DK-5220 Odense Denmark
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(+45) 70 23 05 80 [email protected] 1
Case background •
Classic Pen was a low-cost producer of traditional Blue and Black ink pens
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Classic Pen had a profit margin of at least 20% of sales
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5 years earlier- introduced Red Pens using same technology at 3% premium
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Recently, introduced Purple Pens using same technology at 10% premium.
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Case background Issues facing the Management •
Issue 1 - Profitability
– While Red and Purple pens seem to be more profitable, overall profitability of the company is falling
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Issue 2 - Pricing
– “Tough Global Competition” – – “Can the products be priced better?”
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Issue 3 – Product Mix
– Process for Red and Purple pens require more resources (set-up time etc.)
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Issue 4 – Internal Processes
– A lot of time spent on scheduling and purchasing activities
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Case background The costing system of Classic Pen was simple •
All indirect costs were aggregated at factory level and allocated to products based upon the direct labor cost
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At this time the overhead rate was 300% of direct labor cost
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Before new types of pens were introduced the overhead rate was only 200% of direct labor cost
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Sales cost is allocated in proportion with sales
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Case background Product costing calculated with traditional full costing method
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Activity Based Costing •
Before: – Production primarily manual – Total indirect cost were less that the direct labor cost – Classic Pen’s two products were identical with respect to volume and batch size
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Direct labor cost and indirect cost has decreased due to automation
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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
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Activity Based Costing •
Same physical output, same cost of material
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The firm has approximately
– Property taxes, security cost and heating cost which are unchanged – Much higher indirect and support costs due to the larger and more diversified product mix and more complex production
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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
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The traditional costing system would fundamentally report identical costs for the standard and special products, independent of production volume
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The use of indirect and support activities by the special products are higher that the use by the standard products Walnut +
Activity Based Costing ABC at Classic Pen - Analysis of the cost structure: •
Indirect labor – 50% of the indirect labor costs are caused by what the controller called handling of production batches – 40% of the indirect labor cost were caused by the physical change from one color to another and were called setup costs – 10% of the time was used to an activity which the controller labeled support activities (Parts admin.)
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Computer Expenses – 20% allocated to support activities (Parts admin.) • This is an activity which is already found in the catalogue of activities as it was used to account for the 4 products – 80% of computer resources were used to produce batches and are closely related to handling of production batches
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Activity Based Costing ABC at Classic Pen - Analysis of the cost structure: •
Three categories of indirect cost remained: – Machine depreciation – Machine maintenance – Energy for running the machines
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These costs were incurred to maintain the production capacity for the production of pens. The Controller calls the production activities Running the machines
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Activity Based Costing Expenses
Cost Pools Activities
Products
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Indirect labor/Fringe benefits/computer systems/machinery/maintenance/Ener gy Indirect Labor/Fringe benefits for DL/Computer Expenses/Machine Expenses Machine Setting/Handling Production Batches/Part Administration/Machine Support/Sales Order handling/Key Account Management
Activity Based Costing Define Activities and Activity Drivers Activities • • • • • • •
Handle Production Batches Set up Time Parts Administration Machine Support Direct Labor Fringe Sales Order handling Key Account Management
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Drivers • • • • • • •
Production Batches Setup Hours No. of Parts Machine Hours Direct Labor Sales Orders KAM Hours
Activity Based Costing Understanding Activities: Levels Machine expenses:
Unit Level Activity
Handle Production Runs: Activity
Batch Level
Set up Expenses:
Batch Level Activity
Parts admin. Expenses:
Product Level Activity
Fringe Expenses:
Facility Level
Sales Order handling:
Customer level
Key Account Management: Customer level Walnut +
Activity Based Costing Resources and resource cost pools
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Activity Based Costing Resources to activities
Machine Expenses
Indirect labor
Computer Expenses
Fringe benefits for DL
50%40% 10% 80% Handling
Setup
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Sales support
50% 50% 20% Parts Admin.
Machine Support
Direct Labor Fringe
Sales Order handling
Key Account Manageme nt
Activity Based Costing Data and Cost Drivers
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Results Activity cost
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Results Activity cost per cost object
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Results Income Statement
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Results Income Statement
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Observations •
To produce the new products the company has added large quantity of overheads: Computer systems and support expenses
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So the overheads to the new products are high under ABC. Which, is the correct reflection of the cost determination
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Customer income shows profitable customers and nonprofitable cusotmers
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