2) Problems Faced By Managers can be summarised as follows:

Initially Classic pen Company used to sell only two products consisting of Blue
and Black coloured pens but recently observing the opportunities and scenario it
has been proposed to expand the companies production by introducing new
colours RED and PURPLE being the most recent inclusions.they are also hoping of
including some more new colours in the near future.But Dempsey faced great
disappointments when he observed the year end financial reports because the
new products didn’t seem to earn more profit margin than their original product
consisting of Blue and Black coloured pen.Hence the overall profit has gone
down .Red coloured pens were sold at a premium of 3% and Purple coloured
pens were sold at a premium of 10%.profit margins on Blue and Black coloured
pens were 20%.So Dempsey who is the controller of the Classic Pen Conpany is
investigating what went wrong because of which they didn’t get the desired
results.The various problems faced by the company can be summarised as
under:

• Firstly their recently introduced products in the form of Red and Purple
coloured pens are not earning expected profit margins.

• Their overall profit has declined.

• They are in a dilemma whether to introduce some more range of new

products because customers are willing to pay more for the speciality
coloured pens.

• Some of the operational problems arised due to introduction of Red

coloured pens which required more changeovers from the existing
process.Five years ago it was a lot simpler but now the process has
become a lot more complicated because new Purple and Red pens have a
demanding specifications , Red being more demanding.

• They tend to spend a lot of time on purchasing and scheduling activities

and just keeping track of where they stood on existing , backlogged and
future orders.

• A routing sheet identified the sequence of operations required for each

operating step.This information was used to calculate the labour expenses
for each operating step.All plants indirect expenses were aggregated at
the plant level and allocated to products based on their direct labour
content.Currently the overhead burden rate was 300% of the direct
labour cost while it was 200% just few years back.

The above mentioned problems are important specially because company wants
to introduce some new range of products so without knowing the causes of
current problems it would not be healthy to go ahead with new introductions.Also
they need to know why the new products are giving less profit margins than the
old products.As competition intensifies , companies are increasingly producing
greater variety of products and services.Using broad averages to uniformly
spread the cost of resources across different products results in inaccurate and
misleading product costs.one of the causes for low profit margin could be one of
the primitive methods like broad averaging methods used to allocate costs.This
method of cost allocating results in greater inaccuracy of product costs.for
example the use of a single plantwide manufacturing overhead rate to allocate
costs to products often produces unreliable cost data.In the above case too all
plant indirect expenses were aggregated at the plant level and allocated to
products based on their direct labour content.Hence this led to overhead direct
burden of 300% a 100% increase from what it was initially(before introduction of
new products).

3) An approach for soving the problem.

According to the given case the controller of the company attends a seminar in
which Activity –based costing was discussed . He wants to implement this system
of costing because this concept seemed to address many problems faced by the
company.Now we discuss about the Activity based costing.

Activity – based costing is the best tools for refining costing system.Activity
based costing refines a costing system by identifying individual activities as the
fundamental cost objects.An activity is an event , task, or unit of work with a
specified purpose-for example designing products , setting up machines,
operating machines, and distributing products.ABC systems calculate the costs
of individual activities and assign costs to cost objects such as products and
services on the basis of the activities needed to produce each product or service

For many years, construction firms and industry trade groups have
collected cost data from a multitude of different construction projects. The
amount of work associated with that cost was also collected with the cost
data. For example, collected data included the cost of the paint, labor,
equipment, and overhead to paint a room, the amount of surface area
painted, and the manpower required to paint the room. This practice
allowed construction professionals to obtain a cost per area and manpower
per area. These costs are based on an activity, such as painting, and are
known as ABC. ABCs are discussed in detail in the following sections.

A. Activity Based Costing Definition

ABC can be roughly defined by the following equation:

C/A = HD + M + E + S

where C/A = Estimated cost per activity

H = Number of labor hours required to perform the activity one time

D = Wages per labor hour

M = Material costs required to perform the activity one time

E = Equipment costs to perform the activity one time

S = Subcontracting costs to perform the activity one time

The total cost for performing the activity will be based on the number of times the
activity is performed during a specific time frame.

Cost estimators have assembled large databases of activity based cost information.

Finally the ABC method can be done in the steps as follows:

• identification of significant activities

• accumulation of activity costs

• selection of a relevant cost driver

• estimation of a driver rate

• final allocation or assignment

The basic cost drivers in modern manufacturing environment are:

• number of set-upsk..

• number of engineering change-orders

• number of customer orders

• number of non standard parts used

• number of invoices processes

Learning from the suggested reading:

ABC methodology is used when a project can be divided into defined

activities.

These activities are at the lowest function level of a project at which

costs are tracked and performance is evaluated. Depending on the
project organization, the activity may coincide with an element of the
work breakdown structure (WBS) or may combine one or more
elements of the WBS. However, the activities must be defined so
there is no overlap between them. After the activity is defined, the
unit of work is established. All costs for the activity are estimated
using the unit of work.

The estimates for the units of work can be done by performing

detailed estimates, using cost estimating relationships, obtaining
outside quotes for equipment, etc. All costs including overhead,
profit, and markups should be included in the activity cost.

Here in the given case Dempsey identifies six categories of support expenses
that were currently being allocated to pen production.

• Indirect Labour costing $20000

• Fringe Benefits costing $16000

• Computer system costing $10000

• Machinery costing $8000

• Maintenance costing $4000

• Energy costing $ 2000

• Total cost $ 60000