Case Classic Pen Company Activity Based Costing

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
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(+45) 70 23 05 80
[email protected]
1
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 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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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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Case background
Product costing calculated with traditional full costing method
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Before:
Production primarily manual
Total indirect cost were less that the direct labor cost
Classic Pens 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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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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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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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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Expenses
Cost Pools
Activities
Products
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Indirect labor/Fringe
benefits/computer
systems/machinery/maintenance/Ener
gy
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

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

Understanding Activities: Levels
Machine expenses:
Unit Level Activity
Handle Production Runs:

Activity
Batch Level
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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Resources and resource cost pools
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Resources to activities
Machine
Expenses
Indirect
labor
Computer
Expenses
Fringe
benefits for
DL
50%40% 10%
80%
Handling
Setup
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Sales
support
50% 50%
20%
Parts
Admin.
Machine
Support
Direct
Labor
Fringe
Sales
Order
handling
Key
Account
Manageme
nt

Data and Cost Drivers
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Results
Activity cost
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Results
Activity cost per cost object
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Results
Income Statement
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Results
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 nonprofitable cusotmers
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Case Classic Pen Company Activity Based Costing

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What issues is the management of Classic Pen facing?

What issues is the management of Classic Pen facing?

How does the traditional costing system work at Classic Pen?

How does the traditional costing system work at Classic Pen?

Activity Based Costing

Classic Pen was a low-cost producer of traditional Blue and

Classic Pen had a profit margin of at least 20% of sales

5 years earlier- introduced Red Pens using same technology

Recently, introduced Purple Pens using same technology at

While Red and Purple pens seem to be more profitable, overall

Tough Global Competition

Issue 3 Product Mix

Issue 4 Internal Processes

A lot of time spent on scheduling and purchasing activities

All indirect costs were aggregated at factory level and

Before new types of pens were introduced the overhead

Sales cost is allocated in proportion with sales

Activity Based Costing

Direct labor cost and indirect cost has decreased due to

As low volume products were introduced the result was

Activity Based Costing

Same physical output, same cost of material

The firm has approximately

One unit of the high volume standard product (blue or black)

The traditional costing system would fundamentally report

The use of indirect and support activities by the special

Activity Based Costing

Activity Based Costing

Three categories of indirect cost remained:

These costs were incurred to maintain the production

Activity Based Costing

Activity Based Costing

Handle Production Batches

Activity Based Costing

Unit Level Activity

Handle Production Runs:

Batch Level Activity

Parts admin. Expenses:

Product Level Activity

Sales Order handling:

Key Account Management: Customer level

Activity Based Costing

Activity Based Costing

Activity Based Costing

To produce the new products the company has added large

So the overheads to the new products are high under ABC.

Customer income shows profitable customers and nonprofitable cusotmers

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