1. Managerial Accounting – Classic Pen Company Case
09/04/2013
Archana Mohan
Deepak Shivamurthy
Gurpreet Singh
Krishnamma Muniswamy
Manohar Rao
Padmesh Mishra
Rahul Ravikanth
Robin Scaria
Satya Peesapati
Subrat Sahu
GMITE7- Group 7

2. Key Topics
Case Background? -5 min
Key Questions we need to answer – 1 min
Why is Traditional Costing wrong – 2 min
Activity Based Costing – 8 min
Inference/Observations/Recommendations – 8 min
Any questions? 1-2 min

3. Case Background

4. What’s the background?
Classic pen company had been the low cost producer of BLUE and BLACK Pens.
Profit margins of over 20% of sales.
Introduced Red pens 5 years back, as technology required was same, and premium of 3% could be charged.
Last year introduced purple pens with premium of 10%.
All pens use same technology and production facility.
Overheads burden rate increased from 200% to 300% with introduction of the new colors.

5. Issues highlighted in the case?
Red and Purple pens seems profitable, but overall profitability is down
Is this due to tougher competition or something else?
Purple pens are showing higher margins, so should we introduce more colors?
Are consumers willing to pay more prices for special colors?

6. Key Questions we need to answer

7. Key Questions we need to answer?
By introducing more colors with premium in selling price, profitability is down. Is my cost analysis right?
Calculate the revised product costs for the four pens based on activity information collected.
What actions are stimulated by the ABC product costs?

8. Why is traditional costing wrong?

9. Traditional Income Statement
Blue
Black
Red
Purple
Total
Sales
$75,000
$60,000
$13,950
$1,650
$150,600
Material Costs
$25,000
$20,000
$4,680
$550
$50,230
Direct Labor
$10,000
$8,000
$1,800
$200
$30,000
$24,000
$5,400
$600
Total Operating Income
$2,070
$300
$20,370
Return on Sales (Contribution Margin)
13.3%
14.8%
18.2%
13.5%
Why is above costing wrong?
Excerpts from Manufacturing Manager:
More change overs with introduction of low volume colored pens
Lots of time taken to stop production, empty vats, clean previous color
Demanding specifications for Red and Purple, as compared with Blue and Black.
Lot of time spent in purchase, scheduling and keeping track of existing, backlogged and future orders.
New computer system introduced due to new colors, but cost is attributed to all colored pens equally.
TI operating expense is high
Salaries
Rents
Utility bills
Interest payments
Retiral benefits
Supplier costs

10. Why is above costing wrong?
All indirect expenses are aggregated and allocated to products based on their direct labor content.
Above seems to be the MISTAKE, as there’s a lot of over head expenses introduced with RED and PURPLE pens, but cost is distributed equally against all 4 300% of the direct labor.
Solution?
Need to calculate actual costs and allocate that against each of the products?
Derive next steps based on the new cost analysis?
TI operating expense is high
Salaries
Rents
Utility bills
Interest payments
Retiral benefits
Supplier costs

11. Activity Based costing

12. Over Head Expenses Categorized
Expense Category
Expense
Comments
Indirect labor
$20,000
50%: Scheduling and handling production runs 40%: Physical changeover for color change 10%: Maintaining records
Fringe Benefits
$16,000
40% of labor expenses (direct(20k) and indirect(20k))
Computer Systems
$10,000
80% involved in production run activity 20% keep records for four products
Machinery Depreciation
$8,000
Practical capability of hours Based on volume or machine hours
Machine Maintainence
$4,000
Based on volume or machine hours
Energy
$2,000
Total
$60,000
  TOTAL OVERHEAD EXPENSES IN CURRENT SETUP
TI operating expense is high
Salaries
Rents
Utility bills
Interest payments
Retiral benefits
Supplier costs
Ok, now we know where are these overhead expenses going
Next step would be to calculate production runs, setup time, administration time for the current volumes of the colored pens, and allocate costs accordingly.

13. Direct cost and activity cost drivers
Blue
Black
Red
Purple
Total
Production Sales Volume (numbers)
50000
40000
9000
1000
100000
Unit selling price
$1.5
$1.6
$1.7
Direct Material Costs
$25,000
$20,000
$4,680
$550
$50,230
Materials unit cost
$0.50
$0.52
$0.55
Direct Labor
$10,000
$8,000
$1,800
$200
Direct labor hrs/unit
0.02
2000
Direct labor unit cost
$10
Machine hours/unit
0.1
Machine hours
5000
4000
900
100
10000
Parts administration 1 4
Setup time/run 6
Production quantity/run
800
Total Setup time (hours)
200 50
228 48
526
Production Runs 38 12
150
TI operating expense is high
Salaries
Rents
Utility bills
Interest payments
Retiral benefits
Supplier costs
Expenses in Green: These are the direct expenses, and increase/decrease in proportion to the volume.
Expenses in Red: These are the one that determine overhead expense allocation based on setup time, production runs and parts administration.
The ones in black are per unit expenses, and used to calculate total expenses based on volume

14. Activity based costing
Blue
Black
Red
Purple
Total
Number of units
50000
40000
9000
1000
100000
Sales
$75,000
$60,000
$13,950
$1,650
$150,600
Direct Material Costs
$25,000
$20,000
$4,680
$550
$50,230
Direct labor Costs($10 per hour)
$10,000
$8,000
$1,800
$200
Overhead
Indirect labor- Setup costs
$3,041.83
$760.46
$3,467.68
$730.04
$8,000.0
Indirect labor - Handling Production Runs
$3,333.33
$2,533.33
$800.00
$10,000.0
Indirect labor - Maintaining
$500.00
$2,000.0
Fringe Benefits (40% of direct)
$4,000.00
$3,200.00
$720.00
$80.00
$8,000.00
Fringe Benefits (40% of indirect)
$2,750.06
$1,837.52
$2,600.41
$812.02
Computer Systems - Handling Production Runs
$2,666.67
$2,026.67
$640.00
Computer Systems - Maintaining Records
$500.0
$2,000.00
Machinery Depreciation (Proportion to volume)
$4,000
$3,200
$720
$80
Machine Maintainence (Propotion to volume)
$2,000
$1,600
$360
$40
Energy (Propotion to volume)
$1,000
$800
$180
$20
Total Overhead
$23,791.89
$18,397.97
$13,608.09
$4,202.05
$60,000.00
Total Variable Costs
$58,791.89
$46,397.97
$20,088.09
$4,952.05
$130,230.00
Total operating Income/ Contribution
$16,208.11
$13,602.03
-$6,138.09
-$3,302.05
$20,370.00
Return on sales/ Contribution Margin
21.61%
22.67%
-44.00% %
13.53%
TI operating expense is high
Salaries
Rents
Utility bills
Interest payments
Retiral benefits
Supplier costs

15. Total variable cost per unit (ACTIVITY BASED COSTING METHOD)
Per Unit Contribution
Blue
Black
Red
Purple
Unit Selling Price
$1.50
$1.55
$1.65
Materials Unit Cost
$0.50
$0.52
$0.55
Direct Labor/unit
$0.20
Overhead cost/unit
$0.48
$0.46
$1.51
$4.20
Total variable cost per unit
$1.18
$1.16
$2.23
$4.95
Contribution per unit
$0.32
$0.34
-$0.68
-$3.30
Oops!!!
Blue
Black
Red
Purple
Total
Return on Sales
(TRADITIONAL METHOD)
13.3%
14.8%
18.2%
13.5%
Return on sales
(ACTIVITY BASED COSTING METHOD)
21.61%
22.67%
-44.00% %
13.53%
TI operating expense is high
Salaries
Rents
Utility bills
Interest payments
Retiral benefits
Supplier costs

16. What did we learn?
Contribution margin of Purple Pens is the -200%. Increasing volumes will hurt more.
Contribution margin of Red Pens is also -44%. Increasing volumes will hurt more, unless price is adjusted.
Contribution margins of Black and Blue pens stands 22%, against 13% as suggested by traditional method.
Company is making losses of around $10,000 by producing Red and Purple Pens, due to huge overhead costs, and incorrect pricing.
TI operating expense is high
Salaries
Rents
Utility bills
Interest payments
Retiral benefits
Supplier costs

17. Recommendations

18. Option 1: Eliminate “Red” and “Purple” and increase Black by 9k units
Blue
Black
Red
Purple
Total
Number of units
50000
100000
Sales
$75,000 $0
$150,000
Direct Material Costs
$25,000
$50,000
Direct labor Costs($10 per hour)
$10,000
$20,000
Overhead
Indirect labor- Setup costs
$3,041.83
$950.57
$0.00
$3,992.4
Indirect labor - Handling Production Runs
$3,333.33
$4,166.67
$7,500.0
Indirect labor - Maintaining
$500.00
$1,000.0
Fringe Benefits (40% of direct)
$4,000.00
$8,000.00
Fringe Benefits (40% of indirect)
$2,750.06
$2,246.89
$4,996.96
Computer Systems - Handling Production Runs
$2,666.67
$6,000.00
Computer Systems - Maintaining Records
$500.0
$0.0
$1,000.00
Machinery Depreciation (Proportion to volume)
$4,000
$8,000
Machine Maintainence (Propotion to volume)
$2,000
Energy (Propotion to volume)
$1,000
Total Overhead
$23,791.89
$22,697.47
$46,489.35
Total Variable Costs
$58,791.89
$57,697.47
$116,489.35
Total operating Income/ Contribution
$16,208.11
$17,302.53
$33,510.65
Return on sales/ Contribution Margin
21.61%
23.07%
0.00%
22.34%
TI operating expense is high
Salaries
Rents
Utility bills
Interest payments
Retiral benefits
Supplier costs

19. TI operating expense is high
Option 2: Eliminate “Purple” and increase Black by 1k units, Retain Red but increase price from $1.6 to $2.5 to make contribution margin > 0
Blue
Black
Red
Purple
Total
Number of units
50000
41000
9000
100000
Sales
$75,000
$61,500
$22,500 $0
$159,000
Direct Material Costs
$25,000
$20,500
$4,680
$50,180
Direct labor Costs($10 per hour)
$10,000
$8,200
$1,800
$20,000
Overhead
Indirect labor- Setup costs
$3,041.83
$779.47
$3,467.68
$0.00
$7,289.0
Indirect labor - Handling Production Runs
$3,333.33
$3,416.67
$2,533.33
$9,283.3
Indirect labor - Maintaining
$500.00
$1,500.0
Fringe Benefits (40% of direct)
$4,000.00
$3,280.00
$720.00
$8,000.00
Fringe Benefits (40% of indirect)
$2,750.06
$1,878.45
$2,600.41
$7,228.92
Computer Systems - Handling Production Runs
$2,666.67
$2,733.33
$2,026.67
$7,426.67
Computer Systems - Maintaining Records
$500.0
$0.0
$1,500.00
Machinery Depreciation (Proportion to volume)
$4,000
$3,280
$720
$8,000
Machine Maintainence (Propotion to volume)
$2,000
$1,640
$360
Energy (Propotion to volume)
$1,000
$820
$180
Total Overhead
$23,791.89
$18,827.92
$13,608.09
$56,227.90
Total Variable Costs
$58,791.89
$47,527.92
$20,088.09
$126,407.90
Total operating Income/ Contribution
$16,208.11
$13,972.08
$2,411.91
$32,592.10
Return on sales/ Contribution Margin
21.61%
22.72%
10.72%
0.00%
20.50%
TI operating expense is high
Salaries
Rents
Utility bills
Interest payments
Retiral benefits
Supplier costs

20. Our Recommendation
Choose Option 1, if price of RED is competitive and can’t be increased.
Gives maximum return of 22.34%.
Setup and processes are efficiently utilized, so overheads are less
Only issue is that company will loose it’s diversity of product by shutting down RED and PURPLE.
Choose Option 2, if price of RED can be played with.
Gives good return of 20.5%.
Setup and processes are not that efficiently utilized, but overheads due to RED are absorbed in it’s premium price.
Some diversity of product will remain (BLACK, BLUE and RED)
TI operating expense is high
Salaries
Rents
Utility bills
Interest payments
Retiral benefits
Supplier costs
Other recommendations.
Using same facility for colored pens doesn’t make sense. Company should setup a new facility for RED and PURPLE Pens, in case fixed costs are justified. This will reduce overhead costs of setups(change color).
In case company retains RED, it can introduce Bundle offer to boost sales. For example Blue(1.18) + Red(2.23) bundle minimum for Rs 3.41, etc.

21. Any Questions?