Activity-based cost systems

Case:

The classic pen company

 Classic pen company
Facts:
Low-cost producer of traditional BLUE and
BLACK pens
Profit margin: over 20% of sales
Declining trend in operating results
Opportunity for adding new products:
1. Red pen introduced five years before with same
technology at 3% premium
2. Purple pen introduced with 10% premium last
year
 Issues before management
Premium products (Red & Purple) more
profitable, but overall profitability is down
Even new products margin declining in face of
competition
Introduction of new pens requires: more
activities (more resources?)
More set-up time (max. for red pen)
More purchasing and scheduling time
 Present cost system
Features:
Single overhead absorption rate
Direct labour cost is the base
Rate is 300% of DLC
Previously it was 200% (indicates increase
in indirect expenses)
 Traditional cost sheet
Blue Black Red Purple Total

DM 25000 20000 4680 550 50230

DL 10000 8000 1800 200 20000

OH (300% 30000 24000 5400 600 60000

of DL)

Total cost 65000 52000 11880 1350 130230

Sales 75000 60000 13950 1650 150600

Operating 10000 8000 2070 300 20370

income

Margin 13.3 13.3 14.8 18.2 13.5

(%)
 ABC
Overhead is not a burden to be allocated on top of
direct labour
Identify activities of indirect and support resource
of the entity
Relate the cost of these activities to the products
for which they are performed
Condition:
large overhead (46% of TC) and multiple products
may be ABC would help
 ABC Analysis
Expenses identified: Rs.
Indirect labour 20,000
Fringe benefits 16,000
Computer Systems 10,000
Machinery 8,000
Maintenance 4,000
Energy 2,000
Total 60,000
 Forming cost pools
Indirect labour Rs. 20,000 + 40% of fringe
benefit, i.e., Rs.8,000 =
Rs.28,000

Computer expenses Rs.10,000

Machine expenses Rs.8,000+Rs.4,000+Rs.2,000

=Rs.14,000
 Activities identified
Scheduling or handling production runs
Production set up
Record keeping
Machine support
Relating activities to activity drivers
Activities Activity drivers
Handling production runs Production runs (150
nos.)
Production set up Setup time (526 hours)

Record keeping No. of products (4)

Machine support Machine hours

(10,000hr)
 Allocation of cost to activities
Indirect % share Comp. % share Machine % share Total
labour expenses expenses

Handling 14,000 50% 8,000 80% 22,000

Productio
n run
Prod. set 11,200 40% 11,200
up

Record 2,800 10% 2,000 20% 4,800

keeping

Machine 14,000 100% 14,000

support
Total 28,000 10,000 14,000 52,000
 New cost system-ABC
Blue Black Red Purple Total
DM+DL 35,000 28,000 6,480 750 70,230
Fringe benefit 4,000 3,200 720 80 8,000
Overheads
Handling prod. Run 7,333 7,333 5,573 1,760 22,000
Prod. Set up 4,259 1,065 4,855 1,022 11,200
Record keeping 1,200 1,200 1,200 1,200 4,800
Machine support 7,000 5,600 1,260 140 14,000
Total overhead 19,792 15,198 12,888 4,122 52,000
Total cost 58,792 46,398 20,088 4,952 130,230
Sales 75,000 60,000 13,950 1,650 150,600
Profit 16,208 13,602 -6,138 -3,302 20,370
Profit margin(%) 21.6 22.7 -44 -200.1 13.5
 Comparison of OH share
Traditional cost system ABC system

Blue - 30,000 Blue - 19,792

Black -24,000 Black 15,198
Red - 5,400 Red -12,888
Purple - 600 Purple 4,122
 Comparison of Margin
Traditional cost system ABC system

Blue - 13.3% Blue - 21.6%

Black 13.3% Black 22.7%
Red - 14.8% Red - (-44%)
Purple - 18.2% Purple (-200.1%)
 Conclusion
Addition of new products has resulted in
increase of overheads
New product mix means disproportionate
demand on resources of the organisation
due to unequal activity content that goes
into different products
ABC can result in more accurate costing in
such cases