Activity-Based Cost Systems

The Classic Pen Company

 The Classic Pen Company – A Case for
Activity Based Costing

Introduction:
• Low-cost producer of traditional Blue and Black ink
pens
• Profit margins of over 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.
 Classic Pen Company – Issues facing the
Management
ISSUE 1 - Profitability
While Red & 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.)
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ISSUE 4 – Internal Processes
A lot of time spent on
scheduling and purchasing
activities
 Conventional Cost Sheet
Blue Black Red Purple Total
DM 25,000 20,000 4,680 550 50,230
DL 10,000 8,000 1,800 200 20,000
OV 30,000 24,000 5,400 600 60,000
Total Cost 65,000 52,000 11,880 1,350 130,230

Sales 75,000 60,000 13,950 1,650 150,600

Profit 10,000 8,000 2,070 300 20,370

Profit Marging 13% 13% 15% 18% 14%

 Shift in Costing: To ABC

Expenses Indirect labour/Fringe benefits/computer

systems/machinery/maintenance/Energy

Cost Pools Indirect Labour/Computer Expenses/Machine

Expenses

Activities Machine Setting/Handling Production Runs/Part

Administration/Machine Support

Products
 Classic Pen: Define Activities and
Activity Drivers
Activities Drivers

• Handle Production • Production Runs

Runs • Setup hours
• Set up Time • No. of Parts
• Parts Administration • Machine Hours
• Machine Support • Direct Labour
• Direct Labour Fringe
Understanding Activities: Levels

• Machine expenses: Unit Level Activity

• Handle Production Runs: Batch Level
Activity
• Set up Expenses: Batch Level Activity
• Admin. Expenses: Product Level Activity
• Fringe Expenses: Facility Level
Forming Cost Pools: Under ABC

Indirect Labour 28,000 20000 + 8000 (40% 0f direct labor)

Computer Expenses 10,000
Machine Expense 14,000 (8000+4000+2000)

These expenses to be apportioned over the activities

mentioned in the previous slides using the
appropriate drivers.
 Cost Allocation: Under ABC
Indirect labour Computer Exp. Machine Exp Total Activity Rate
Handle Production Runs 50% 14,000 80% 8,000 22,000 150 146.7
Set up Time 40% 11,200 11,200 526 21.29
Parts Administration 10% 2,800 20% 2,000 4,800 4 1200
Machine Support 100% 14000 14,000 10000 1.4

Total 28,000 10,000 14000 52,000

 How can the Classic Pen Company discover
what its true costs are?
OLD WAY
(What is spent?) Activity Based Costing

Traditional accounting
INDIRECT LABOUR $ 20,000

FRINGE BENEFITS $ 8,000 SCHEDULE PRODUCTION RUNS $ 22,000

COMPUTER SYSTEMS $ 10,000 SET UP $ 11,200

DEPRECIATION $ 8,000 ADMINISTRATION

NEW WAY $ 4, 800
MAINTENANCE $ 4,000 (How is it
MACHINE SUPPORT
ENERGY
spent?) $ 14,000
$ 2,000
TOTAL $ 52,000 TOTAL $ 52,000

Step 1 – Map resource Costs

to Activities
 ABC Cost Sheet
Blue Black Red Purple Total
50,000 40,000 9,000 1,000 100,000
DM 25,000 20,000 4,680 550 50,230
DL 10,000 8,000 1,800 200 20,000
40% Fringe Benefits 4,000 3,200 720 80 8,000
Overheads
Machine Support 7,000 5,600 1,260 140 14,000
Prod Run Exp. 7,333 7,333 5,573 1,760 22,000
Set up Exp. 4,259 1,065 4,855 1,022 11,200
Admin Exp 1,200 1,200 1,200 1,200 4,800
TotalOverheads 19,792 15,198 12,888 4,122 52,000

Total Cost 58,792 46,398 20,088 4,952 130,230

CPU 1.18 1.16 2.23 4.95
Sales 75,000 60,000 13,950 1,650 150,600
1.50 1.50 1.55 1.65
Profit 16,208 13,602 -6,138 -3,302 20,370
Profit/unit 0.32 0.34 -0.68 -3.30
Profit Margin 22% 23% -44% -200% 14%
 OVERHEADS

Overhead Breakup - Traditional Costing Overhead Breakup - Activity Based Costing

Purple
Red Purple 7%
9% 1% Red Blue
23% 39%

Black
Blue Black
40%
50% 31%
 Traditional vs. ABC

Return on Sales BLUE BLACK RED PURPLE TOTAL

(ABC) 21.6% 22.7% -44.0% -200.1% 13.5%
(Traditional) 13.3% 13.3% 14.8% 18.2% 13.5%
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