Jane Dempsey, controller of the Modern Pen Company, was concerned about the recent financial trends in operating results. modern Pen had been the low-cost producer of traditional BLUE pens and BLACK pens. Profit margins were over 20% of sales.

Several years earlier Dennis Selmor, the sales manager, had seen opportunities to expand the business by extending the product line into new products that offered premium selling prices over traditional BLUE and BLACK pens. Five years earlier, RED pens had been introduced; they required the same basic production technology but could be sold at a 10% premium. And last year, PURPLE pens had been introduced because of the 18% premium in selling price they could command. But Dempsey had just seen the financial results (see Exhibit 1) for the most recent fiscal year and was keenly disappointed.

The new RED and PURPLE pens do seem more profitable than our BLUE and BLACK pens, but overall profitability is down, and even the new products are not earning the margins we used to see from our traditional products. Perhaps this is the tougher global competition. I have been reading about. At least the new line, particularly PURPLE pens, is showing much higher margins. Perhaps we should follow Dennis’s advice and introduce even more specialty colored pens. Dennis claims that consumers are willing to pay higher prices for these specialty colors.

Exhibit 1. Traditional Income Statement

Exhibit 1. Traditional Income Statement

BLUE BLACK RED PURPLE TOTAL

Sales $75,000 $60,000 $14,850 $1,770 $ 151,620

Material costs 25,000 20,000 4,680 550 $50,230

Direct labor 10,000 8,000 1,800 200 $20,000

Overhead (300% direct labor)30,000 24,000 5,400 600 $ 60,000

Total operatine income $10,000 $8,000 $2,970 $420 $21,390

Return on sales 13.33% 13.33% 20.00% 23.73% 14.11%

Jeffrey Donald, the manufacturing manager, was also reflecting on the changed environment at modern Pen:

Five years ago, life was a lot simpler. We produced just BLUE and BLACK pens in long production runs, and everything ran smoothly, without much intervention. Difficulties started when the RED pens were introduced and we had to make more changeovers. This required us to stop production, empty the vats, clean out all remnants of the previous color, and then start the production of the red ink. Making black ink was simple; we didn’t even have to clean out the residual blue ink from the previous run if we just dumped in enough black ink to cover it up. But for the RED pens, even small traces of the blue or black ink created quality problems. And the ink for the new PURPLE pens also has demanding as for RED pens. We seem to be spending a lot more time on purchasing and scheduling activities and just keeping track of where we stand on existing, backlogged, and future orders. The new computer system we got last year helped a lot to reduce the confusion. But I am concerned about rumors I keep hearing that even more new colors may be introduced in the near future. I don’t think we have any more capability to handle additional confusion and complexity in our operations.

Operation modern produced pens in a single factory. The mayor task was preparing and mixing the ink for the different-colored pens. The ink was inserted into the pens in a semi automated process. A final packing and shipping stage was performed manually.

Each product had a bill of materials that identified the quantity and cost of direct materials required for the product. A routing sheet identified the sequence of operations required for each operating step. This information was used to calculate the labor expenses for each of the four products. All of the plant’s indirect expenses were aggregated at the plant level and allocated to products on the basis of their direct labor content. Currently, this overhead burden rate was 300% of direct labor cost. Most people in the plan recalled that not too many years ago the overhead rate was only 200%.

Activity-Based Costing

Jane Dempsey had recently attended a seminar of her professional organization in which a professor had talked about a new concept, called activity-based costing (ABC). This concept seemed to address many of the problems she had been seeing at modern Pen. The speaker had even used an example that seemed to capture modern ’s situation exactly. The professor had argued that overhead should not be viewed as a cost or a burden to be allocated on top of direct labor. Rather, the organization should focus on activities performed by the indirect and support resource of the organization and try to link the cost of performing these activities directly to the products for which they were performed. Dempsey obtained several books and articles on the subject and soon tried to put into practice the message she had heard and read about.

Dempsey first identified six categories of support expenses that were currently being allocated to pen production:

EXPENSE CATEGORY EXPENSE

Indirect labor $20,000

Fringe benefits 16,000

Computer systems 15,000

Machinery 5,000

Maintenance 2,000

Energy 2,000

Total $60,000

She determined that the fringe benefits were 40% of labor expenses (both direct and indirect) and would thus represent just a percentage markup to be applied on top of direct and indirect labor charges. Dempsey interviewed department heads in charge of indirect labor and found that three main activities accounted for their work. About half of indirect labor was involved in scheduling or handling production runs. This production included scheduling production orders; purchasing, preparing, and releasing materials for the production run; performing a first-item inspection every time the process settled down. Another 40% of indirect labor was required just for the physical changeover from one color pen to another.

The time to change over to BLACK pens was relatively short (about 1 hour) since the previous color did not have to be completely eliminated from machinery. Other colors required longer changeover times; RED pens required the most extensive changeover to meet the demanding quality specification for this color.

The remaining 10% of the time was spent maintaining records on the four products, including the bill of materials and routing information, monitoring and maintaining a minimum supply of raw materials and finished goods inventory for each product, improving the production processes, and performing engineering changes for the products.

Dempsey also collected information on potential activity cost drivers for modern ’s activities (see Exhibit 2) and the distribution of the cost drivers for each of the four products. Dempsey next turned her attention to the $15,000 of expenses to operate the company’s computer system. She interviewed the managers of the Data Center and the Management Information System departments and found that most of the computer’s time (and software expense) was used to schedule production runs in the factory and to order and pay for the materials required in each production run.

Exhibit 2. Direct costs and Activity Cost Drivers

BLUE BLACK RED PURPL ETOTAL

Production sales (no.of units) 50,000 40,000 9,000 1,000 100,000

Unit selling price $1.50 $1.50 $1.65 $1.77

Material/unit cost $0,50 $0,50 $0.52 $0.55

Direct labor hr/unit 0.02 0.02 0.02 0.02 2,000

Machine hr/unit 0.1 0.1 0.1 0.1 10,000

No.of production runs 50 50 38 12 150

Setup time/run (hours) 4 1 5 4

Total setup time (hours) 200 50 190 48 526

Number of products 1 1 1 1 4

Because each production was made for a particular customer, the computer time required to prepare shipping documents and to invoice and collect from a customer was also included in this activity. In total, about 70% of the computer resource was involved in the production run activity. Almost all of the remaining computer expense (30%) was used to keep records on the four products, including production process and associated engineering change notice information. The remaining three categories of overhead expense (machine depreciation, machine maintenance, and the energy to operate the machines) were incurred to supply machine capacity to produce the pens. The machines had a practical capacity of 10,000 hours of productive time that could be supplied to pen production.

Dempsey believed that she now had the information she needed to estimate an activity-based cost model for modern Pen.

Required

1. Estimate the costs for the four pen products using an activity-based approach.

2. What are the managerial implications from the revised cost estimates?