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Classic Pen CompanyCase Analysis Activity Based Cost System
Group -07
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The Classic Pen Company
Introduction
Classic Pen Company waslow-cost producer of traditional
Blue and Black ink pens
Profit margins were over 20% ofsales
As part ofproduct diversification introduced Red and Purplecolored pens
5 years earlier- introduced Red Pens using same technology
expected to sold at 3%premium
A year back, introduced Purple Pens using same technology
expected to sold 10%premium
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Company Operation
The major task was preparing & mixing the ink for the different color
pens
The Ink was inserted into the pens in asemi automated process
A final packing & shipping stage was performed manually
Each product had a bill of materials that identified the
quantity & cost of direct materials required for the product
All the plants indirect expenses were aggregated at the plant level &
allocated to product based on their direct labour content
The sequence of operations for each operating steps were identified
through routing sheet which is used to calculate the labour expenses
for each of the four products based on the direct labour content
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Management Concern
Red & Purple pensseem to be more profitable but
overall profitability of the company is falling
Better pricing due to global competition
To process Red and Purple pen, it requires moreresource(more setup time)
Scheduling and purchasing activities takeslot of time
All the 4 products failed to generate expected return
Overhead burden rate 300% of the direct labour
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Views From SalesMgr,ManufacturingMgr & Controller
DENNIS SELMOR (Sales Manager) Opportunities to expand the business by extending the
product line into new products that offered premium
selling price over traditional Blue & Black
Consumersare willing to pay higher prices for the special
colors
JEFFRYDONALD(ManufacturingManager) Making blue and black pen wassimple
Purple pen having demanding specification nut not as
much as Red
Concerned about the future rumorslike
introducing of new colors would hamper the
operations in the company
Jane Dempsey (Controller)
Disappointed afterseen the financial results of thecompany
Wanted to put Activity based Costing( termed asABC here
after) Approach into practice
Identified the six categories ofsupport expenses that were
currently being allocated to pen production
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Exhibit 1
Exhibit 1 Traditional Income Statement
Blue Black Red Purple Total
Sales 75,000 60,000 13,950 1,650 1,50,600
MaterialCost 25,000 20,000 4,680 550 50,230
Direct La bour 10,000 8,000 1,800 200 20,000
Overhead @300% 30,000 24,000 5,400 600 60,000Total Operating
Income 10,000 8,000 2,070 300 20,370
Return on Sales 13.33% 13.33% 14.84% 18.18% 13.53%
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Exhibit 2
Exhibit 2 Direct Costs and Activity Cost Drivers
Blue Black Red Purple Total
Production Sales
Volume 50,000 40,000 9,000 1,000 1,00,000
Unit selling Price 1.50 1.50 1.55 1.65
Materilas-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 0.10 0.10 0.10 0.10 10,000
Production runs 50 50 38 12 150
Setup time/run 4 1 6 4
Total Setup time (hrs) 200 50 228 48 526
PartsAdministration 1 1 1 1 4
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Assumptions While UsingABC
Fringe benefits - 16000 (40% of direct and indirect labour)
1st Approach :
Allocating fringe benefits equally - 20% or 8000 to direct labourand
8000 to indirect labour
So, indirect labour is treated as 20000 + 8000 (FB) = 28000
2nd Approach :
Allocating entire fringe benefits (16000) separately.
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Considering 1stApproach
Cost pool underAB
CIndirect Labour 20,000
40 % of direct labour 8,000
28,000
Computer Systems 10,00010,000
Machinery 8,000
Maintenance 4,000
Energy 2,000
14,000
Total 52,000
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CostAllocation underABC
Indirect
labour
Computer
Exp Machine Exp Total Activity Rate
Handle Production
Run 50% 14,000 80% 8,000 22,000 150 146.7
Setup time 40% 11,200 11,200 526 21.3
Parts
Administration 10% 2,800 20% 2,000 4,800 4 1,200.0
Machine Support 100% 14,000 14,000 10,000 1.4
Total 28,000 10,000 14,000 52,000
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Cost SheetBlue Black Red Purple Total
Production Sales Volume 50,000 40,000 9,000 1,000 1,00,000
MaterialCost 25,000 20,000 4,680 550 50,230
Direct La bour 10,000 8,000 1,800
40% Fringe Benefits 4,000 3,200 720 80 8,000
Overheads
Machine Support 7,000 5,600 1,260 140 14,000Prod Run Exp. 7,333 7,333 5,573 1,760 22,000
Set up Exp. 4,259 1,065 4,855 1,022 11,200
Admin Exp 1,200 1,200 1,200 1,200 4,800
TotalOverheads 19,792 15,198 12,888 4,122 52,000
Total Cost 58,792 46,398 20,088 4,952 1,30,230
CPU 1.18 1.16 2.23 4.95Sales 75,000 60,000 13,950 1,650 1,50,600
1.5 1.5 1.55 1.65
Profit 16,208 13,602 -6,138 -3,302 20,370
Profit/unit 0.32 0.34 -0.68 -3.3
Profit Margin 22% 23% -44% -200% 14%
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Using 2ndApproach
* Cost of labor per hour: $10
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Over HeadBreakup
Activity Based CostingTraditionalCosting
Return on Sales BLUE BLACK RED PURPLE TOTAL
Traditional 13.3% 13.3% 14.8% 18.2% 13.5%
ABC 21.6% 22.7% -44.0% -200.1% 13.5%
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Tradeoff between red and purple
Red runs Purple runs Red cost Purple cost
38 12 2.23 4.97
37 15 2.22 4.69
36 18 2.21 4.5
35 21 2.2 4.35
34 24 2.19 4.23
33 27 2.18 4.13
30 36 2.16 3.91
25 49 2.15 3.69
20 64 2.15 3.5
15 78 2.19 3.36
10 92 2.32 3.24
5 106 2.8 3.13
ProductMix Simulation
2
2.5
3
3.5
4
4.5
5
12 15 18 21 24 27 36 49 64 78 92 106
38 37 36 35 34 33 30 25 20 15 10 5
Red cost
Purple cost
If you reduce the production of red pens and use the capacity to produce purple
pens this slide shows the trend of cost of purple pen.
This can be extended to find the optimal product mix.
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Observations and suggestions
Return on Sales ofBlue, Black, Red ,Purplepens are 21.6% ,22.7%,- 44.0% ,- 200.1% respectively
To produce the new product the company hasadded large quantity of overhead such asComputer
System & Support Expenses
T
he overhead to the new product are high underABC method which is positive reflect ofcost determination
Conclusion 1:
As Red & Purple incurring huge amount of loss hence the production should be stopped given
the current demand and plant capacity. Since we do not know the fixed cost we cannot take a
decision based on marginal cost of producing red and purple pen.
Conclusion 2:
If plans to continue all the product line the following pointsshould be explored further
More marketing for Purple pen to increase the customer base
Changing product mix to take advantage of Economy of Scale
Increasing the capacity in terms of no. of lines and Quantity per batch .
Increase the selling price for the Purple and Red
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Group 07Team Members AdbulAhad
Ananth Rao
Ashish Nair
Ankit Rustagi
Anupriya Sen
Dushyant Singh
Hudson Moses
Subrahmanyam Chavali
THANKYOU !!!