Cladograms

1. CLASSIC PEN COMPANY
DEVELOPING AN ABC MODEL
GROUP 10 (SECTION D)
ARIJIT NAYAK 15P189
CHANDRIMA DHAR 15P194
MIHIR UPASANI 15P212
NIDIHIN G THOMAS 15P215
SAMBIT DASH 15P225
SHIVI SHARMA 15P230
VIVEK AGGARWAL 15P240

2. Case Background
• Originally, Company was a low-cost producer of traditional Blue a
nd Black pens
• Profit margins were over 20% of sales
• Five years earlier Red pens were introduced at 3% premium
• Recently Purple pens were introduced using same technology at
10% premium
• Company only has one factory where all production is carried out

3. Issues faced by Management
• Issue 1 – Profitability
• While Red and Purple pens seem to be more profitable, ov
erall profitability of the company is falling
• Issue 2 - Pricing
• Can the products be priced better
• Issue 3 – Production Process
• Process for Red and Purple pens requires more set-up time
• Issue 4 – Internal Processes
• A lot of time spent on scheduling and purchasing activities
• No capability to handle additional confusion and complexit

4. Costing system of Classic Pen
• All indirect costs were aggregated at plant level and all
ocated to products based upon the direct labor cost
• The current overhead rate is 300% of direct labor cost
• Before Red and Purple pens were introduced, the over
head rate was only 200% of direct labor cost

5. Traditional Costing Method
Classic Pen Company
Traditional Income Statement
Blue Black Red Purple Total
Sales $ 75,000.00 $ 60,000.00 $ 13,950.00 $ 1,650.00 $ 150,600.00
Direct Material $ 25,000.00 $ 20,000.00 $ 4,680.00 $ 550.00 $ 50,230.00
Direct Labor $ 10,000.00 $ 8,000.00 $ 1,800.00 $ 200.00 $ 20,000.00
Overhead (@ 300% of Direct labor) $ 30,000.00 $ 24,000.00 $ 5,400.00 $ 600.00 $ 60,000.00
Total Costs $ 65,000.00 $ 52,000.00 $ 11,880.00 $ 1,350.00 $ 130,230.00
Operating income $ 10,000.00 $ 8,000.00 $ 2,070.00 $ 300.00 $ 20,370.00
Return on Sales
13.33% 13.33% 14.84% 18.18% 13.53%

6. • Before:
– Production primarily manual
– Classic Pen’s two products were identical with respect to volume and b
atch size
• Direct labor cost and indirect labor cost has decreased due to
automation
• As low volume products were introduced the result was increa
sed demand for:
– Increased planning
– More setups of machines
– More quality control
– Computers to keep track of jobs and product specifications
Activity Based Costing

7. • Same physical output, same cost of direct material
• The firm has much higher indirect and support costs due to
the larger and more diversified product mix and more com
plex production
• One unit of the high volume standard product (blue or blac
k) uses approximately the same amount of direct labor as
one unit of red or purple
• The use of indirect and support activities by the special pro
ducts are higher that the use by the standard products
Activity Based Costing

8. Activity Based Costing
• Indirect labor
– 50% of the indirect labor costs are caused by Handling Pro
duction runs
– 40% of the indirect labor cost were caused by the physical
change from one color to another called Machine Setup co
sts
– 10% of the indirect labor was used to an activity Parts Ad
ministration (Record keeping)
• Computer Expenses
– 20% allocated to keep records (Parts administration)
– 80% of computer resources were used to produce batches
and are closely related to Handling production runs

9. Activity Based Costing
• Three categories of indirect cost remained:
– Machine Depreciation
– Machine Maintenance
– Energy
• These costs were incurred for production of pens and were a f
unction of the machine hours taken to produce the pens (Run
ning of Machines)
• Fringe Benefits were 40% of both direct and indirect labor exp
enses, and were to be applied as a percentage markup to bot
h

10. Activities and Cost Drivers
Expenses
• Indirect labour; Fringe Benefits; Computer Systems; Machinery; Main-
tenance; Energy
Cost Pool
• Indirect labour; Computer System Expenses; Machine Expenses
Activities
• Machine set up; Production run; Parts Administration (Record keeping);
Machine Support
Products
• Black; Blue; Red; Purple

11. Assigning Resources to Activities
Activity
Cost
Handling
production
runs
Machine
Set Up for
changeover
Parts
Administration
Running of
machines Total
Total
Expense
Indirect Labor 50% 40% 10% 100% $ 20,000.00
Fringe benefits (40%
of Indirect Labor) 50% 40% 10% 100% $ 8,000.00
Computer Systems 80% 20% 100% $ 10,000.00
Machine
Depreciation 100% 100% $ 8,000.00
Machine
Maintenance 100% 100% $ 4,000.00
Energy 100% 100% $ 2,000.00
Activity Expense $ 22,000.00 $ 11,200.00 $ 4,800.00 $ 14,000.00 $ 52,000.00

12. Activity Cost Drivers Rate
Activity Handling
production runs
Machine Set
Up for
changeover
Parts
Administration
Running of
machines
Cost Driver Production runs Setup Time No. of products Machine Hours
Cost Driver Quantity 150 526 4 10000
Activity Cost Driver
Rate $ 146.67 $ 21.29 $ 1,200.00 $ 1.40
Cost Driver Blue Black Red Purple Activity Cost Driver
Rate
Production Runs 50 50 38 12 $ 146.67
Set up time 200 50 228 48 $ 21.29
Products 1 1 1 1 $ 1,200.00
Machine Hours 5000 4000 900 100 $ 1.40

13. ABC Income statement
Classic Pen Company
ABC Based Income Statement
Blue Black Red Purple Total
Sales $ 75,000.00 $ 60,000.00 $ 13,950.00 $ 1,650.00 $ 150,600.00
Direct Material $ 25,000.00 $ 20,000.00 $ 4,680.00 $ 550.00 $ 50,230.00
Direct Labor $ 10,000.00 $ 8,000.00 $ 1,800.00 $ 200.00 $ 20,000.00
Fringe Benefits (Direct Labor
portion) $ 4,000.00 $ 3,200.00 $ 720.00 $ 80.00 $ 8,000.00
Handling Production Runs $ 7,333.33 $ 7,333.33 $ 5,573.33 $ 1,760.00 $ 22,000.00
Machine Set up for
changeover $ 4,258.56 $ 1,064.64 $ 4,854.75 $ 1,022.05 $ 11,200.00
Parts Administration $ 1,200.00 $ 1,200.00 $ 1,200.00 $ 1,200.00 $ 4,800.00
Running of Machines $ 7,000.00 $ 5,600.00 $ 1,260.00 $ 140.00 $ 14,000.00
Total Costs $ 58,791.89 $ 46,397.97 $ 20,088.09 $ 4,952.05 $ 130,230.00
Operating income $ 16,208.11 $ 13,602.03 $ (6,138.09) $ (3,302.05) $ 20,370.00
Return on Sales 21.61% 22.67% -44.00% -200.12% 13.53%

14. Cost per unit vs. Selling Price per unit
Blue Black Red Purple
ABC Cost per Unit $ 1.18 $ 1.16 $ 2.23 $ 4.95
Traditional Cost per
Unit $ 1.30 $ 1.30 $ 1.32 $ 1.35
Selling Price $ 1.50 $ 1.50 $ 1.55 $ 1.65

15. Observations
 Return on sale varies based on the traditional costing method and
ABC method
 Red color pens are sold at price less than its cost as per ABC
 Purple color pens are sold at much less price than its cost
 Company is making loss in selling Red and Purple color pens as the
overhead cost is high
 Overheads increased significantly with new products as company has
added large quantity of overheads: computer systems and support
expenses

16. Recommendations based on ABC analysis
• Increase the sales price of red and purple pens
• Improve processes to reduce setup times, especially f
or Red pens
• Look for new product designs and efficient methods o
f preparing and mixing inks