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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

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Herluf Trolles Vej 243DK-5220 Odense

Denmark

(+45) 70 23 05 80

info@walnutplus.com

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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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Case backgroundIssues 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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Case backgroundThe 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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Case backgroundProduct costing calculated with traditional full costing method

Traditional income StatementBlue Black Red Purple Total

Sales 75.000 60.000 13.950 1.650 150.600Material costs 25.000 20.000 4.680 550 50.230Direct Labor 10.000 8.000 1.800 200 20.000Markup @ 300% of Direct Labor 30.000 24.000 5.400 600 60.000Sales cost 4.980 3.984 926 110 10.000Total Cost 69.980 55.984 12.806 1.460 140.230Total Operating income 5.020 4.016 1.144 190 10.370Return on sales 6,69% 6,69% 8,20% 11,54% 6,89%

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• 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

Activity Based Costing

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• 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

Activity Based Costing

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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

Activity Based Costing

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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

Activity Based Costing

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Expenses

Cost Pools

Activities

Products

Indirect labor/Fringe benefits/computer systems/machinery/maintenance/Energy

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

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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

Drivers

• Production Batches• Setup Hours• No. of Parts• Machine Hours• Direct Labor• Sales Orders• KAM Hours

Activity Based Costing

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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

Activity Based Costing

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Activity Based CostingResources and resource cost pools

Resources (Indirect cost)Expense

Indirect labor 30.000Fringe benefits 16.000Computer systems 10.000Machinery 8.000Maintenance 4.000Energy 2.000Total 70.000

Resources (direct cost)Expense

Material costs 50.230Direct Labor 20.000Total 70.230

Total cost 140.230

Resources Cost Pools

Indirect Labor

Fringe benefits for

DLComputer Expenses

Machine Expenses

Sales support Total

20.000 10.000 30.0008.000 8.000 16.000

10.000 10.0008.000 8.0004.000 4.0002.000 2.000

28.000 8.000 10.000 14.000 10.000 70.000

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Indirect labor Fringe benefits for DL

Computer Expenses

Machine Expenses Sales support

50% 40% 10%

80%

Activity Based CostingResources to activities

50% 50%

20%

Handling Setup Parts Admin. Machine Support

Direct Labor Fringe

Sales Order handling

Key Account Management

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Activity Based CostingData and Cost Drivers

Direct costs and cost driversBlue Black Red Purple Total

Production quantities 50.000 40.000 9.000 1.000 100.000Sales 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 2.000Machine Hours per unit 0,1 0,1 0,1 0,1 10.000Number of Production batches 50 50 38 12 150Setup Hours per batch 4 1 6 4Total setup time (Hours) 200 50 228 48 526Number of products 1 1 1 1 4

Sales quantities and Cost Drivers for customersDepartment

Store ADepartment

Store BDepartment

Store CBook Store

1Book Store

2 TotalSales quantities Blue 30.000 9.000 9.000 1.000 1.000 50.000Sales quantities Black 25.000 10.000 4.900 92 8 40.000Sales quantities Red 7.000 700 900 300 100 9.000Sales quantities Purple 300 200 200 100 200 1.000Sales quantities total 62.300 19.900 15.000 1.492 1.308 100.000Sales 93.845 29.915 22.575 2.268 1.997 150.600Sales orders 36 12 12 6 50 116KAM Hours 600 200 200 50 200 1.250

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Results

ActivitiesActivit cost

Activity Cost Driver

Cost driver quantity

Cost Driver rate Per

Handle Production Batches 22.000 Production Batches 150 146,67 BatchSet up Time 11.200 Setup Hours 526 21,29 HourParts Administration 4.800 No. of Parts 4 1.200,00 ProductMachine Support 14.000 Machine Hours 10.000 1,40 HourDirect Labor Fringe 8.000 Direct Labor cost 20.000 0,40 DLcostSales Order handling 5.000 Sales Orders 116 43,10 OrderKey Account Management 5.000 KAM Hours 1.250 4,00 HourTotal 70.000

Activity cost

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Results

Activities Blue Black Red Purple TotalHandle 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

ActivitiesDepartment

Store ADepartment

Store BDepartment

Store CBook Store

1Book Store

2 TotalSales 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

Activity cost per cost object

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Results

Activity Based Costing income StatementBlue Black Red Purple Total

Sales 75.000 60.000 13.950 1.650 150.600Material costs 25.000 20.000 4.680 550 50.230Direct Labor 10.000 8.000 1.800 200 20.000Handle Production Batches 7.333 7.333 5.573 1.760 22.000Set up Time 4.259 1.065 4.855 1.022 11.200Parts Administration 1.200 1.200 1.200 1.200 4.800Machine Support 7.000 5.600 1.260 140 14.000Direct Labor Fringe 4.000 3.200 720 80 8.000Total Production Cost 58.792 46.398 20.088 4.952 130.230Total Operating income 16.208 13.602 -6.138 -3.302 20.370Return on sales 21,61% 22,67% -44,00% -200,12% 13,53%Sales Cost 10.000Net income 10.370Return on sales 6,89%

Income Statement

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Results

Customer incomeDepartment

Store ADepartment

Store BDepartment

Store C Book Store 1 Book Store 2 TotalSales 93.845 29.915 22.575 2.268 1.997 150.600Cost goods sold 81.384 24.735 19.266 2.447 2.399 130.230Sales Order handling 1.552 517 517 259 2.155 5.000Key Account Management 2.400 800 800 200 800 5.000Customer income 8.510 3.863 1.992 -638 -3.357 10.370Return on sales 9,07% 12,91% 8,83% -28,13% -168,10% 6,89%

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

• 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