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Executive Summary

Classic Pen Company used to get a profit margin of over 20% of sales when they used to produce

traditional low-cost Blue and Black ink pens. They decided to expand to Red and Purple ink pens. In spite

of these selling at a premium, the profit percentage fell to 13.5%. It is only when an activity-based cost

model is adopted does the underlying problem of margins comes to the forefront.

Issues at Classic Pen Company

ProfitabilityRed and Purple pens seem more profitable using the traditional method of allocating Indirect

Cost but the overall profitability of the company is falling.

PricingDue to tough global competition, the company needs to decide the pricing of the products

accordingly.

Product MixRed and Purple pens require more resources in terms of indirect cost.

Internal ProcessesOperational inefficiency in scheduling and purchasing activities are contributing to higher costs

as per calculations.

Observations

The excessive indirect costs are due to the high overhead costs introduced for the new products Activity-based costing reveals the actual indirect cost distribution for the new products

Activities Drivers

Handle Production Runs Production Runs

Setup Time Setup hours

Parts Administration No of parts

Machine Support Machine Hours

Direct Labour Fringe Direct Labour

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Expenses Activity

Machine Expenses Unit Level Activity

Production Runs Expenses Batch Level Activity

Setup Expenses Batch Level Activity

Administration Expenses Production Level Activity

Fringe Expenses Facility Level Activity

Recommendation

Increase prices of the Red and Purple pens to 2.43 and 4.95 respectively to achieve break-even.Thus, overall profit margin increases to 18.63

Increase prices of the Red and Purple pens to 2.79 and 6.19 respectively to achieve 20% profitmargin. Thus, overall profit margin increases to 21.68

Operational efficiency can be increase by more production of red and purple pens perProduction Run. It is currently low due to order-drive production method which could be

changed to produce-and-sell method. However, inventory holding cost needs to be accounted

for.

Eg: For Purple pens, the production run could be brought down from 12 to 1 run to produce

1000 pens bringing down production costs for these pens.