CLASSIC PEN COMPANY

DEVELOPING AN ABC MODEL

(REF-Harvard Business School 9-198-117 Rev. September 17,1998)

CASE STUDY ANALYSIS

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CASE SUMMARY
Classic Pen was a low cost producer of blue and black
pens
Profit margins were 20% of sales
5 years earlier red pens were introduced to Classics
business line to be sold at 3% premium
Last year purple color pens were introduced to be sold
at 10% premium

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MANAGEMENT DILEMMA
Red & purple pens seem profitable but overall profit
margins are down
Set up times are more for red & purple pen
Excessive time being spent on purchasing & scheduling

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TRADITIONAL COSTING SYSTEM AT CLASSIC PEN COMPANY

All indirect costs were aggregated at plant level and allocated to the products based upon
the direct labor cost
The current overhead rate is 300%
Before red and purple pens were introduced to Classics product lines, the overhead rate
was 200% of direct labor cost

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ACTIVITY BASED COST MODEL

Set up machines
Run Machine
Parts
Administration
Direct Labor

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# of production
runs
Set up hours
# of machine
hours
# of units
Labor hours

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Products

Handle Production
Runs

Drivers

Support Expenses (ref classic pen case)

Indirect labor
20,000
Fringe Benefits
16,000
Computer
system
10,000
Machinery
8,000
Maintenance
4,000
Energy
2,000

Activity Based Model For Classic Pen Company

Activities

Support Expenses

Blue Pens
Black Pens
Red Pens
Purple Pens

ACTIVITY BASED COST MODEL

Activity Cost Working (pool)
In accordance to the case, indirect labor is divided into three parts 50% in Handling Production runs

14,400

40% In Machine Set ups

11,520
2,880

10% In parts administration

Fringe Benefits (Professional opinion - Fringe benefits held by labor can at times be more than supervision staff insurances, union

rates, etc)
Direct Labor Fringe (45% of total fringe cost professional judgement)

7,200

Indirect Labor Fringe (55% of total fringe cost - professional judgement)

8,800 (Pooled with indirect labor in

production, set up & parts admin in
same proportion described above)

Computer system costs is absorbed by two activities

80% in Handling Production runs

8,000

20% In parts administration

2,000

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ACTIVITY BASED COST MODEL

Activity Level
Machine Expenses
Handle Production Runs

Unit Level Activity

Batch Level Activity

Set Up Expenses
Parts Administration

Batch Level Activity

Product Level Activity

Fringes

Plant wide Level Activity

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TABLE 1 ACCUMULATE ACTIVITY COSTS

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ACTIVITY COST DISTRIBUTION PER PRODUCT

Activities at different levels
Production sales volume
Unit Selling Price
Material Unit Cost
Material Cost (Total Production Level)
Direct Labour Hrs/Unit
Direct labour cost incl fringe/unit
Direct labour cost incl fringe/unit (TPL)
Production Runs
Handle Production Runs/unit
Handle Production Runs/unit (TPL)
Total Set up time
Set up /unit
Set up /unit (TPL)
Machine hours/unit
Machine costs/ Eq costs
Machine costs/ Eq costs (TPL)
Parts administration cost
Parts administration cost (TPL)
Total unit cost of produced pen
Total Cost of Produced Pens
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Blue

Black

50000
1.50
0.50
25000.00

Red

0.27
13600.00
50.00
0.15
7466.67
200.00
0.09
4380.23
0.10
0.14
7000.00
0.05
2440.00

40000
1.50
0.50
20000.00
0.02
0.27
10880.00
50.00
0.19
7466.67
50.00
0.03
1095.06
0.10
0.14
5600.00
0.05
1952.00

1.20
59886.89

0.02

Purple
9000
1.55
0.52
4680.00

0.14
1260.00
0.05
439.20

1000
1.65
0.55
550.00
0.02
0.27
272.00
12.00
1.79
1792.00
48.00
1.05
1051.25
0.10
0.14
140.00
0.05
48.80

1.17

2.17

3.85

46993.72

19495.33

3854.05

0.02
0.27
2448.00
38.00
0.63
5674.67
228.00
0.55
4993.46
0.10

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TABLE 2 PRODUCT COSTS

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CLASSIC PEN COMPANY INCOME STATEMENT

(ACTIVITY BASED COSTING MODEL)

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CASE 2

Case 2 Unrecorded inspection amount of $5,000, how do we handle it?

Solution - Add it the Handle production runs activity and re-evaluate the costs for each
pen
Next Slide for revised cost calculations for Case 2

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CASE 2 - TABLE 1 ACCUMULATE ACTIVITY COSTS

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CASE 2 - TABLE 2 PRODUCT COSTS

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CASE 2 - CLASSIC PEN COMPANY INCOME

STATEMENT (ACTIVITY BASED COSTING MODEL)
Product

Blue

Black

Red

Purple

TOTAL

Sales

$75,000

$60,000

$13,950

$1,650

$150,600

Expense

$61,886.89

$48,993.72

$21,015.33

$4,334.05

$136,230

Operating
income

$13,113.11

$11,006.28

-$7,065.33

-$2,684.05

$14,370

Return on
sales

17.48%

18.34%

-50.65%

-162.67%

9.54%

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GOALS

Calculate the revised product costs for the pens, based on the activity information collected by
Dempsey
Blue
Black
Red
Purple
Unit cost of production (ABC)
1.20
1.17
2.17
3.85
Unit cost of production (Traditional Costing)
1.30
1.30
1.32
1.35
Unit Selling Price
1.50
1.50
1.55
1.65

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GOALS

What actions are stimulated by the ABC product costs?

Senior management at Classic pens is able to realize that they are loosing money on red and purple pens, against their belief of
earning a significant profit margins on the Red and Purple pens

Blue and black pens are earning profits (before tax) of 20.15% & 21.68%, whereas the red & purple pens are making losses of 39.75%
& 133.58% respectively

Production of Blue & Black pens should be increased, matching a demand increase created by Classic Pen Company (to be created in
parallel)

Increase sales price of red & purple pen to at least match break-even point plus the mark-ups decided by senior management

If red & purple are made for special batch orders, then increase the batch size of the orders considering the effect of order size on unit
cost

Benchmark to best competition to attain higher productivity and reduced set up time to set red color

Utilize better procurement and scheduling processes inefficiencies in scheduling, and procuring department need to be analyzed

Utilize techniques as JIT (Just in time), IMLP (Inter company materials logistic planning) to ensure that there is not a lot of delay in
procurement as well as time spent in coordination with material sub-contractors regarding procurement.

A capital investment towards buying a separate machine to produce red pens can be considered if demand increases and they are
sufficient backlog to promote this decision

It can also be considered to outsource production of red pens to another company who can provide a lower cost of production

Training needs to be provided to direct and indirect labor to improve productivity and efficiency

Direct labor to be accountable for milestone target numbers to enforce production increases, however at the same time ensure that
quality is not compromised

Avoid excess wastage of black paint to wash over blue ink in the machines

Check the amount of testings required if they are excessive testing happening currently, and there is no value add on the quality of
the product

Practise lean production, whereby all material is stored near to the machine, well sorted and organized, to be able to utilized as soon
as a set-up is required.

Avoid set up of red when blue & black production is in full swing mode. Optimize the frequency of the number of times a change over
to red is required

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UNUSED CAPACITIES
Suppose there are unused capacities, how do we handle it?
Costs related to unused capacities should be recorded separately and shouldnt be added to the cost of the
product
Maximum capacity for each resource should be utilized to obtain pre-determined rates
Unused capacities should be clearly recorded as unplanned and planned
Unplanned unused capacities should be investigated for inefficiencies and addressed, and to ensure that
costs for unplanned unused capacities has not been burdened onto the product cost, thereby avoiding the
death spiral
Planned unused capacities should also be reevaluated to validate the uncertainties, maintenance of
equipment, holidays, etc other reasons that were considered to keep a planned unused capacity in the
system
By the use of ABC cost model, unused capacity is efficiently traceable and thereby can be investigated and
corrected, if deemed necessary. For eg if they were a area of the plant owned by Classic Pen, which is not
being used for factory operations, then it could be leased for someother economic purpose and Classic Pen
could accrue rent from their unused fixed asset.
All resources such as machines, direct and indirect labor, procurement and planning service time, set up
process, etc should be benchmarked against the best in the market, and an understanding of maximum
capacities of each resource should be estimated. It is not possible to benchmark to theoretical capacities
and that shouldnt be done.
All data to be collected from the past and the market regarding demand and supply variance in the market,
peak demand and low supply of raw material times, logistics issues, etc any such driver that
effects/causes unplanned unused capacity. This data should be analyzed for potential risks, and strategy
should be formulated to best counter these risks in the future, thereby causing excessive unused capcity.

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