Classic Pen Company: Developing an ABC ModelThe Classic Pen Company CaseJane Dempsey, controller of...Classic...

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Classic Pen Company: Developing an ABC Model
The Classic Pen Company Case
Jane Dempsey, controller of the Classic Pen Company, wasconcerned about the recent financial trends in operating results.Classic Pen had been the low-cost producer of traditional BLUE pensand BLACK pens. Profit margins were over 20% of sales.
Several years earlier Dennis Selmor, the sales manager, had seenopportunities to expand the business by extending the product lineinto new products that offered premium selling prices overtraditional BLUE and BLACK pens. Five years earlier RED pens hadbeen introduced, which required the same basic productiontechnology but could be sold at a 3% premium. And last year PURPLEpens had been introduced because of the 10% premium in sellingprice 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 ourBLUE and BLACK pens, but overall profitability is down and even thenew products are not earning the margins we used to see from ourtraditional products. Perhaps this is the tougher globalcompetition I have been reading about. At least the new line,particularly PURPLE pens, is showing much higher margins. Perhapswe should follow Dennis' advice and introduce even more specialtycolored pens. Dennis claims that consumers are willing to payhigher prices for these specialty colors.
Jeffrey Donald, the manufacturing manager, was also reflectingon the changed environment at Classic Pen:
Five years ago, life was a lot simpler. We produced just BLUEand BLACK pens in long production runs, and everything ransmoothly, without much intervention. Difficulties started when theRED pens were introduced and we had to make more changeovers. Thisrequired us to stop production, empty the vats, clean out allremnants of the previous color, and then start the production ofthe red ink. Making black ink was simple; we didn't even have toclean out the residual blue ink
Professor Robert S. Kaplan prepared this case as the basis forclass discussion rather than to illustrate either effective orineffective handling of an administrative situation.
Classic Pen Company: Developing an ABC Model from the previousrun if we just dumped in enough black ink to cover it up. But forthe RED pens, even small traces of the blue or black ink createdquality problems. And the ink for the new PURPLE pens also hasdemanding specifications, but not quite as demanding as for REDpens.
We seem to be spending a lot more time on purchasing andscheduling activities and just keeping track of where we stand onexisting, backlogged, and future orders. The new computer system wegot last year helped a lot to reduce the confusion. But I amconcerned about rumors I keep hearing that even more new colors maybe introduced in the near future. I don't think we have any morecapability to handle additional confusion and complexity in ouroperations.
Operations
Classic produced pens in a single factory. The major task waspreparing and mixing the ink for the different colored pens. Theink was inserted into the pens in a semiautomated process. A finalpacking and shipping stage was performed manually.
Each product had a bill of materials that identified thequantity and cost of direct materials required for the product. Arouting sheet identified the sequence of operations required foreach operating step. This information was used to calculate thelabor expenses for each of the four products. All of the plant'sindirect expenses were aggregated at the plant level and allocatedto products based on their direct labor content. Currently thisoverhead burden rate was 300% of direct labor cost. Most people inthe plant recalled that not too many years ago the overhead ratewas only 200%.
Activity-Based Costing
Jane Dempsey had recently attended a seminar of her professionalorganization in which a professor had talked about a new concept,called activity-based costing (ABC). This concept seemed to addressmany of the problems she had been seeing at Classic. The speakerhad even used an example that seemed to capture Classic's situationexactly.
The professor had argued that overhead should not be viewed as acost or a burden to be allocated on top of direct labor. Rather,the organization should focus on activities performed by theindirect and support resource of the organization and try to linkthe cost of performing these activities directly to the productsfor which they were performed.
Dempsey obtained several books and articles on the subject andsoon tried to put into practice the message she had heard and readabout.
Activity-Based Cost Analysis
Dempsey first identified six categories of support expenses thatwere currently being allocated to pen production:
ExpenseCategory                                    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 laborexpenses (both direct and indirect) and would thus represent just apercentage markup to be applied on top of direct and indirect laborcharges.
Dempsey interviewed department heads in charge of indirect laborand found that three main activities accounted for their work.About half of indirect labor was involved in scheduling or handlingproduction runs. This included scheduling production orders,purchasing, preparing, and releasing materials for the productionrun, first-item inspection performed every time the process waschanged over, and some scrap loss at the beginning of each rununtil the process settled down. Another 40% of indirect labor wasrequired just for the physical changeover from one color pen toanother.
The time to change over to BLACK pens was relatively short(about 1 hour) since the previous color did not have to becompletely eliminated from the machinery. Other colors requiredlonger changeover times; RED pens required the most extensivechangeover to meet the demanding quality specification for thiscolor.
The remaining 10% of the time was spent maintaining records onthe four products, including the bill of materials and routinginformation, monitoring and maintaining a minimum supply of rawmaterials and finished goods inventory for each product, improvingthe production processes, and performing engineering changes forthe products.
Dempsey also collected information on potential activity costdrivers for Classic's activities (see Exhibit 2) and thedistribution of the cost drivers for each of the four products.
Dempsey next turned her attention to the $10,000 of expenses tooperate the company's computer system. She interviewed the managersof the Data Center and the Management Information Systemdepartments and found that most of the computer's time (andsoftware expense) was used to schedule production runs in thefactory and to order and pay for the materials required in eachproduction run.
Since each production run was made for a particular customer,the computer time required to prepare shipping documents and toinvoice and collect from a customer was also included in thisactivity. In total, about 80% of the computer resource was involvedin the production run activity. Almost all of the remainingcomputer expense (20%) was used to keep records on the fourproducts, including production process and associated engineeringchange notice information.
The remaining three categories of overhead expense (machinedepreciation, machine maintenance, and the energy to operate themachines) were incurred to supply machine capacity to produce thepens. The machines had a practical capability of 10,000 hours ofproductive time that could be supplied to pen production.
Dempsey believed she now had the information to estimate anactivity-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
DirectLabor            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 SellingPrice                       $1.50         $1.50            $1.55    $1.65
Materials-unitcost                  $0.50          $0.50            $0.52         $0.55
Direct laborhrs/unit               0.02            0.02              0.02            0.02           2,000
Machinehrs/unit                     0.1               0.1                 0.1             0.1            10,000
Productionruns                       50                 50                38              12               150
Setuptime/run                          4                   1                  6                 4
Total setuptime                     200                50                228            48               526
Parts Administration          1                  1                 1              1                4
Discuss the Exhibit 1 financial results in light of the insightsprovided by an activity-based analysis of Classic Pen’s operations,and recommend specific management action in response to theinsights.

Answer & Explanation Solved by verified expert

3.6 Ratings (570 Votes)

Income statement as per ABC allocation of Ohs Blue Black Red Purple Total OH allocation basis 1Sales 75000 60000 13950 1650 150600 Less aMaterial costs 25000 20000 4680 550 50230 bDirect Labor 10000 8000 1800 200 20000 cIndirect Labor 3333 3333 2533 800 10000 prodnruns 50503812 3042 760 3468 730 8000 See Answer

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In: AccountingClassic Pen Company: Developing an ABC ModelThe Classic Pen Company CaseJane Dempsey, controller of...Classic Pen Company: Developing an ABC ModelThe Classic Pen Company CaseJane Dempsey, controller of the Classic Pen Company, wasconcerned about the recent financial trends in operating results.Classic Pen had been the low-cost producer of traditional BLUE pensand BLACK pens. Profit margins were over 20% of sales.Several years earlier Dennis Selmor, the sales manager, had seenopportunities to expand the business by extending the product lineinto new products that offered premium selling prices overtraditional BLUE and BLACK pens. Five years earlier RED pens hadbeen introduced, which required the same basic productiontechnology but could be sold at a 3% premium. And last year PURPLEpens had been introduced because of the 10% premium in sellingprice 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 ourBLUE and BLACK pens, but overall profitability is down and even thenew products are not earning the margins we used to see from ourtraditional products. Perhaps this is the tougher globalcompetition I have been reading about. At least the new line,particularly PURPLE pens, is showing much higher margins. Perhapswe should follow Dennis' advice and introduce even more specialtycolored pens. Dennis claims that consumers are willing to payhigher prices for these specialty colors.Jeffrey Donald, the manufacturing manager, was also reflectingon the changed environment at Classic Pen:Five years ago, life was a lot simpler. We produced just BLUEand BLACK pens in long production runs, and everything ransmoothly, without much intervention. Difficulties started when theRED pens were introduced and we had to make more changeovers. Thisrequired us to stop production, empty the vats, clean out allremnants of the previous color, and then start the production ofthe red ink. Making black ink was simple; we didn't even have toclean out the residual blue inkProfessor Robert S. Kaplan prepared this case as the basis forclass discussion rather than to illustrate either effective orineffective handling of an administrative situation.Classic Pen Company: Developing an ABC Model from the previousrun if we just dumped in enough black ink to cover it up. But forthe RED pens, even small traces of the blue or black ink createdquality problems. And the ink for the new PURPLE pens also hasdemanding specifications, but not quite as demanding as for REDpens.We seem to be spending a lot more time on purchasing andscheduling activities and just keeping track of where we stand onexisting, backlogged, and future orders. The new computer system wegot last year helped a lot to reduce the confusion. But I amconcerned about rumors I keep hearing that even more new colors maybe introduced in the near future. I don't think we have any morecapability to handle additional confusion and complexity in ouroperations.OperationsClassic produced pens in a single factory. The major task waspreparing and mixing the ink for the different colored pens. Theink was inserted into the pens in a semiautomated process. A finalpacking and shipping stage was performed manually.Each product had a bill of materials that identified thequantity and cost of direct materials required for the product. Arouting sheet identified the sequence of operations required foreach operating step. This information was used to calculate thelabor expenses for each of the four products. All of the plant'sindirect expenses were aggregated at the plant level and allocatedto products based on their direct labor content. Currently thisoverhead burden rate was 300% of direct labor cost. Most people inthe plant recalled that not too many years ago the overhead ratewas only 200%.Activity-Based CostingJane Dempsey had recently attended a seminar of her professionalorganization in which a professor had talked about a new concept,called activity-based costing (ABC). This concept seemed to addressmany of the problems she had been seeing at Classic. The speakerhad even used an example that seemed to capture Classic's situationexactly.The professor had argued that overhead should not be viewed as acost or a burden to be allocated on top of direct labor. Rather,the organization should focus on activities performed by theindirect and support resource of the organization and try to linkthe cost of performing these activities directly to the productsfor which they were performed.Dempsey obtained several books and articles on the subject andsoon tried to put into practice the message she had heard and readabout.Activity-Based Cost AnalysisDempsey first identified six categories of support expenses thatwere currently being allocated to pen production:ExpenseCategory ExpenseIndirect Labor…………………………………….. $20,000Fringe Benefits……………………………………. 16,000Computer Systems……………………………… 10,000Machinery…………………………………………… 8,000Maintenance………………………………………. 4,000Energy ………………………………………………….2,000Total…………………………………………………… $60,000She determined that the fringe benefits were 40% of laborexpenses (both direct and indirect) and would thus represent just apercentage markup to be applied on top of direct and indirect laborcharges.Dempsey interviewed department heads in charge of indirect laborand found that three main activities accounted for their work.About half of indirect labor was involved in scheduling or handlingproduction runs. This included scheduling production orders,purchasing, preparing, and releasing materials for the productionrun, first-item inspection performed every time the process waschanged over, and some scrap loss at the beginning of each rununtil the process settled down. Another 40% of indirect labor wasrequired just for the physical changeover from one color pen toanother.The time to change over to BLACK pens was relatively short(about 1 hour) since the previous color did not have to becompletely eliminated from the machinery. Other colors requiredlonger changeover times; RED pens required the most extensivechangeover to meet the demanding quality specification for thiscolor.The remaining 10% of the time was spent maintaining records onthe four products, including the bill of materials and routinginformation, monitoring and maintaining a minimum supply of rawmaterials and finished goods inventory for each product, improvingthe production processes, and performing engineering changes forthe products.Dempsey also collected information on potential activity costdrivers for Classic's activities (see Exhibit 2) and thedistribution of the cost drivers for each of the four products.Dempsey next turned her attention to the $10,000 of expenses tooperate the company's computer system. She interviewed the managersof the Data Center and the Management Information Systemdepartments and found that most of the computer's time (andsoftware expense) was used to schedule production runs in thefactory and to order and pay for the materials required in eachproduction run.Since each production run was made for a particular customer,the computer time required to prepare shipping documents and toinvoice and collect from a customer was also included in thisactivity. In total, about 80% of the computer resource was involvedin the production run activity. Almost all of the remainingcomputer expense (20%) was used to keep records on the fourproducts, including production process and associated engineeringchange notice information.The remaining three categories of overhead expense (machinedepreciation, machine maintenance, and the energy to operate themachines) were incurred to supply machine capacity to produce thepens. The machines had a practical capability of 10,000 hours ofproductive time that could be supplied to pen production.Dempsey believed she now had the information to estimate anactivity-based cost model for Classic Pen.Exhibit 1 Traditional Income Statement Blue Black Red Purple TotalSales $ 75,000 $ 60,00 $13,950 $1,650 $150,600Material Costs 25,000 20,000 4,680 550 50,230DirectLabor 10,000 8,000 1,800 200 20,000Overhead @300% 30,000 24,000 5,400 600 60,000Total Operating Income $10,000 $8,000 $2,070 $300 $20,370Return on Sales 13.6% 13.3% 14.8% 18.2% 13.5%Exhibit 2 Direct Costs and Activity Cost Drivers Blue Black Red Purple TotalProduction Sales Volume 50,000 40,000 9,000 1,000 100,000Unit SellingPrice $1.50 $1.50 $1.55 $1.65Materials-unitcost $0.50 $0.50 $0.52 $0.55Direct laborhrs/unit 0.02 0.02 0.02 0.02 2,000Machinehrs/unit 0.1 0.1 0.1 0.1 10,000Productionruns 50 50 38 12 150Setuptime/run 4 1 6 4 Total setuptime 200 50 228 48 526Parts Administration 1 1 1 1 4Discuss the Exhibit 1 financial results in light of the insightsprovided by an activity-based analysis of Classic Pen’s operations,and recommend specific management action in response to theinsights.