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Case classic pen company with extension
1. Activity Based Costing Case
Based on Classic Pen Company* with
extensions
Classic Pen Company: Developing an ABC Model, Harvard Business School, September
17, 1998
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Herluf Trolles Vej 243
DK-5220 Odense
Denmark
(+45) 70 23 05 80
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2. Case background
• Classic Pen was a low-cost producer of traditional Blue and Black ink pens
• Classic Pen had a profit margin of at least 20% of sales
• 5 years earlier- introduced Red Pens using same technology at 3%
premium
• Recently, introduced Purple Pens using same technology at 10% premium.
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3. 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
• Issue 2 - Pricing
– “Tough Global Competition” –
– “Can the products be priced better?”
• Issue 3 – Product Mix
– Process for Red and Purple pens require more resources (set-up time etc.)
• Issue 4 – Internal Processes
– A lot of time spent on scheduling and purchasing activities
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4. 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
• At this time the overhead rate was 300% of direct labor cost
• Before new types of pens were introduced the overhead rate was only
200% of direct labor cost
• Sales cost is allocated in proportion with sales
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5. Case background
Product costing calculated with traditional full costing method
Traditional income Statement
Blue Black Red Purple Total
Sales 75.000 60.000 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
Markup @ 300% of Direct Labor 30.000 24.000 5.400 600 60.000
Sales cost 4.980 3.984 926 110 10.000
Total Cost 69.980 55.984 12.806 1.460 140.230
Total Operating income 5.020 4.016 1.144 190 10.370
Return on sales 6,69% 6,69% 8,20% 11,54% 6,89%
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6. 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
• Direct labor cost and indirect cost has decreased due to automation
• 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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7. Activity Based Costing
• Same physical output, same cost of material
• 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
• 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
• The traditional costing system would fundamentally report identical costs for
the standard and special products, independent of production volume
• The use of indirect and support activities by the special products are higher
that the use by the standard products
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8. 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.)
• 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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9. 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
• 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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10. Activity Based Costing
Indirect labor/Fringe benefits/computer
Expenses
systems/machinery/maintenance/Energy
Indirect Labor/Fringe benefits for DL/Computer
Cost Pools
Expenses/Machine Expenses
Machine Setting/Handling Production
Activities
Batches/Part Administration/Machine
Support/Sales Order handling/Key Account
Management
Products
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11. Activity Based Costing
Define Activities and Activity Drivers
Activities Drivers
• Handle Production Batches • Production Batches
• Set up Time • Setup Hours
• Parts Administration • No. of Parts
• Machine Support • Machine Hours
• Direct Labor Fringe • Direct Labor
• Sales Order handling • Sales Orders
• Key Account Management • KAM Hours
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12. Activity Based Costing
Understanding Activities: Levels
Machine expenses: Unit Level Activity
Handle Production Runs: Batch Level Activity
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
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13. Activity Based Costing
Resources and resource cost pools
Resources (Indirect cost) Resources (direct cost)
Expense Expense
Indirect labor 30.000 Material costs 50.230
Fringe benefits 16.000 Direct Labor 20.000
Computer systems 10.000 Total 70.230
Machinery 8.000
Maintenance 4.000
Energy 2.000
Total 70.000 Total cost 140.230
Resources Cost Pools
Fringe
Indirect benefits for Computer Machine Sales
Labor DL Expenses Expenses support Total
20.000 10.000 30.000
8.000 8.000 16.000
10.000 10.000
8.000 8.000
4.000 4.000
2.000 2.000
28.000 8.000 10.000 14.000 10.000 70.000
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14. Activity Based Costing
Resources to activities
Machine Computer Fringe benefits
Indirect labor Expenses for DL Sales support
Expenses
50% 40% 10% 50% 50%
80% 20%
Machine Direct Labor Sales Order Key Account
Handling Setup Parts Admin.
Support Fringe handling Management
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15. Activity Based Costing
Data and Cost Drivers
Direct costs and cost drivers
Blue Black Red Purple Total
Production quantities 50.000 40.000 9.000 1.000 100.000
Sales price per unit 1,50 1,50 1,55 1,65
Cost of material per unit 0,50 0,50 0,52 0,55
Direct Labor Hours per unit 0,02 0,02 0,02 0,02 2.000
Machine Hours per unit 0,1 0,1 0,1 0,1 10.000
Number of Production batches 50 50 38 12 150
Setup Hours per batch 4 1 6 4
Total setup time (Hours) 200 50 228 48 526
Number of products 1 1 1 1 4
Sales quantities and Cost Drivers for customers
Department Department Department Book Store Book Store
Store A Store B Store C 1 2 Total
Sales quantities Blue 30.000 9.000 9.000 1.000 1.000 50.000
Sales quantities Black 25.000 10.000 4.900 92 8 40.000
Sales quantities Red 7.000 700 900 300 100 9.000
Sales quantities Purple 300 200 200 100 200 1.000
Sales quantities total 62.300 19.900 15.000 1.492 1.308 100.000
Sales 93.845 29.915 22.575 2.268 1.997 150.600
Sales orders 36 12 12 6 50 116
KAM Hours 600 200 200 50 200 1.250
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16. Results
Activity cost
Activit Activity Cost Cost driver Cost Driver
Activities cost Driver quantity rate Per
Handle Production Batches 22.000 Production Batches 150 146,67 Batch
Set up Time 11.200 Setup Hours 526 21,29 Hour
Parts Administration 4.800 No. of Parts 4 1.200,00 Product
Machine Support 14.000 Machine Hours 10.000 1,40 Hour
Direct Labor Fringe 8.000 Direct Labor cost 20.000 0,40 DLcost
Sales Order handling 5.000 Sales Orders 116 43,10 Order
Key Account Management 5.000 KAM Hours 1.250 4,00 Hour
Total 70.000
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17. Results
Activity cost per cost object
Activities Blue Black Red Purple Total
Handle Production Batches 7.333,33 7.333,33 5.573,33 1.760,00 22.000,00
Set up Time 4.258,56 1.064,64 4.854,75 1.022,05 11.200,00
Parts Administration 1.200,00 1.200,00 1.200,00 1.200,00 4.800,00
Machine Support 7.000,00 5.600,00 1.260,00 140,00 14.000,00
Direct Labor Fringe 4.000,00 3.200,00 720,00 80,00 8.000,00
23.791,89 18.397,97 13.608,09 4.202,05 60.000,00
Department Department Department Book Store Book Store
Activities Store A Store B Store C 1 2 Total
Sales Order handling 1.551,72 517,24 517,24 258,62 2.155,17 5.000,00
Key Account Management 2.400,00 800,00 800,00 200,00 800,00 5.000,00
3.951,72 1.317,24 1.317,24 458,62 2.955,17 10.000,00
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18. Results
Income Statement
Activity Based Costing income Statement
Blue Black Red Purple Total
Sales 75.000 60.000 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
Handle Production Batches 7.333 7.333 5.573 1.760 22.000
Set up Time 4.259 1.065 4.855 1.022 11.200
Parts Administration 1.200 1.200 1.200 1.200 4.800
Machine Support 7.000 5.600 1.260 140 14.000
Direct Labor Fringe 4.000 3.200 720 80 8.000
Total Production Cost 58.792 46.398 20.088 4.952 130.230
Total Operating income 16.208 13.602 -6.138 -3.302 20.370
Return on sales 21,61% 22,67% -44,00% -200,12% 13,53%
Sales Cost 10.000
Net income 10.370
Return on sales 6,89%
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19. Results
Income Statement
Customer income
Department Department Department
Store A Store B Store C Book Store 1 Book Store 2 Total
Sales 93.845 29.915 22.575 2.268 1.997 150.600
Cost goods sold 81.384 24.735 19.266 2.447 2.399 130.230
Sales Order handling 1.552 517 517 259 2.155 5.000
Key Account Management 2.400 800 800 200 800 5.000
Customer income 8.510 3.863 1.992 -638 -3.357 10.370
Return on sales 9,07% 12,91% 8,83% -28,13% -168,10% 6,89%
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20. Observations
• To produce the new products the company has added large quantity of
overheads: Computer systems and support expenses
• So the overheads to the new products are high under ABC. Which, is the
correct reflection of the cost determination
• Customer income shows profitable customers and non-profitable
cusotmers
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