Managerial Accounting – Classic Pen Company Case

09/04/2013

GMITE7- Group 7Archana MohanDeepak ShivamurthyGurpreet SinghKrishnamma MuniswamyManohar Rao

Padmesh MishraRahul RavikanthRobin ScariaSatya PeesapatiSubrat Sahu

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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

CASE BACKGROUND

• 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.

• 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?

KEY QUESTIONS WE NEED TO ANSWER

• 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?

WHY IS TRADITIONAL COSTING WRONG?

Traditional Income Statement

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Blue Black Red Purple TotalSales $75,000 $60,000 $13,950 $1,650 $150,600

Material Costs $25,000 $20,000 $4,680 $550 $50,230Direct Labor $10,000 $8,000 $1,800 $200 $20,000

Overhead @300% $30,000 $24,000 $5,400 $600 $60,000Total Operating

Income $10,000 $8,000 $2,070 $300 $20,370Return on Sales

(Contribution Margin) 13.3% 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.

Why is above costing wrong?

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• 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 products @ 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?

ACTIVITY BASED COSTING

Over Head Expenses Categorized

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Expense Category Expense Comments

Indirect labor $20,000

50%: Scheduling and handling production runs40%: Physical changeover for color change10%: Maintaining records

Fringe Benefits $16,00040% of labor expenses (direct(20k) and indirect(20k))

Computer Systems $10,00080% involved in production run activity20% keep records for four products

Machinery Depreciation $8,000Practical capability of 10000 hoursBased on volume or machine hours

Machine Maintainence $4,000 Based on volume or machine hoursEnergy $2,000 Based on volume or machine hoursTotal $60,000 TOTAL OVERHEAD EXPENSES IN CURRENT SETUP

• 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.

Direct cost and activity cost drivers

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Blue Black Red Purple Total

Production Sales Volume (numbers) 50000 40000 9000 1000 100000

Unit selling price $1.5 $1.5 $1.6 $1.7 Direct Material Costs $25,000 $20,000 $4,680 $550 $50,230

Materials unit cost $0.50 $0.50 $0.52 $0.55 Direct Labor $10,000 $8,000 $1,800 $200 $20,000

Direct labor hrs/unit 0.02 0.02 0.02 0.02 2000Direct labor unit cost $10 $10 $10 $10 Machine hours/unit 0.1 0.1 0.1 0.1

Machine hours 5000 4000 900 100 10000Parts administration 1 1 1 1 4

Setup time/run 4 1 6 4

Production quantity/run 1000 800 236.84211 83.333333

Total Setup time (hours) 200 50 228 48 526

Production Runs 50 50 38 12 150

• 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

Activity based costing

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Blue Black Red Purple Total

Number of units 50000 40000 9000 1000 100000Sales $75,000 $60,000 $13,950 $1,650 $150,600Direct Material Costs $25,000 $20,000 $4,680 $550 $50,230Direct labor Costs($10 per hour) $10,000 $8,000 $1,800 $200 $20,000Overhead

Indirect labor- Setup costs (@40%) $3,041.83 $760.46 $3,467.68 $730.04 $8,000.0Indirect labor - Handling Production Runs (@50%) $3,333.33 $3,333.33 $2,533.33 $800.00 $10,000.0Indirect labor - Maintaining records(@10%) $500.00 $500.00 $500.00 $500.00 $2,000.0Fringe Benefits (40% of direct) $4,000.00 $3,200.00 $720.00 $80.00 $8,000.00Fringe Benefits (40% of indirect) $2,750.06 $1,837.52 $2,600.41 $812.02 $8,000.00Computer Systems - Handling Production Runs $2,666.67 $2,666.67 $2,026.67 $640.00 $8,000.00

Computer Systems - Maintaining Records $500.0 $500.0 $500.0 $500.0 $2,000.00

Machinery Depreciation (Proportion to volume) $4,000 $3,200 $720 $80 $8,000Machine Maintainence (Propotion to volume) $2,000 $1,600 $360 $40 $4,000

Energy (Propotion to volume) $1,000 $800 $180 $20 $2,000

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 $130,230.00Total operating Income/ Contribution $16,208.11 $13,602.03 -$6,138.09 -$3,302.05 $20,370.00Return on sales/ Contribution Margin 21.61% 22.67% -44.00% -200.12% 13.53%

Per Unit Contribution

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Blue Black Red Purple

Unit Selling Price $1.50 $1.50 $1.55 $1.65Materials Unit Cost $0.50 $0.50 $0.52 $0.55Direct Labor/unit $0.20 $0.20 $0.20 $0.20

Overhead cost/unit $0.48 $0.46 $1.51 $4.20Total variable cost per unit $1.18 $1.16 $2.23 $4.95

Contribution per unit $0.32 $0.34 -$0.68 -$3.30

Blue Black Red Purple TotalReturn on Sales

(TRADITIONAL METHOD) 13.3% 13.3% 14.8% 18.2% 13.5%Return on sales

(ACTIVITY BASED COSTING METHOD) 21.61% 22.67% -44.00% -200.12% 13.53%

Oops!!!

Overhead Costs (Old Way)

Blue

Black

Red

Purple

Overhead Costs (ABC Way)

BlueBlackRedPurple

What did we learn?

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• Contribution margin of Purple Pens is the worst @ -200%. Increasing volumes will hurt more.

• Contribution margin of Red Pens is also negative @ -44%. Increasing volumes will hurt more, unless price is adjusted.

• Contribution margins of Black and Blue pens stands tall @ 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.

RECOMMENDATIONS

Option 1: Eliminate “Red” and “Purple” and increase Black by 9k units

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Blue Black Red Purple Total

Number of units 50000 50000 0 0 100000Sales $75,000 $75,000 $0 $0 $150,000Direct Material Costs $25,000 $25,000 $0 $0 $50,000Direct labor Costs($10 per hour) $10,000 $10,000 $0 $0 $20,000Overhead Indirect labor- Setup costs (@40%) $3,041.83 $950.57 $0.00 $0.00 $3,992.4Indirect labor - Handling Production Runs (@50%) $3,333.33 $4,166.67 $0.00 $0.00 $7,500.0Indirect labor - Maintaining records(@10%) $500.00 $500.00 $0.00 $0.00 $1,000.0Fringe Benefits (40% of direct) $4,000.00 $4,000.00 $0.00 $0.00 $8,000.00Fringe Benefits (40% of indirect) $2,750.06 $2,246.89 $0.00 $0.00 $4,996.96Computer Systems - Handling Production Runs $2,666.67 $3,333.33 $0.00 $0.00 $6,000.00

Computer Systems - Maintaining Records $500.0 $500.0 $0.0 $0.0 $1,000.00

Machinery Depreciation (Proportion to volume) $4,000 $4,000 $0 $0 $8,000Machine Maintainence (Propotion to volume) $2,000 $2,000 $0 $0 $4,000

Energy (Propotion to volume) $1,000 $1,000 $0 $0 $2,000

Total Overhead $23,791.89 $22,697.47 $0.00 $0.00 $46,489.35

Total Variable Costs $58,791.89 $57,697.47 $0.00 $0.00 $116,489.35Total operating Income/ Contribution $16,208.11 $17,302.53 $0.00 $0.00 $33,510.65Return on sales/ Contribution Margin 21.61% 23.07% 0.00% 0.00% 22.34%

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

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Blue Black Red Purple Total

Number of units 50000 41000 9000 0 100000

Sales $75,000 $61,500 $22,500 $0 $159,000Direct Material Costs $25,000 $20,500 $4,680 $0 $50,180Direct labor Costs($10 per hour) $10,000 $8,200 $1,800 $0 $20,000Overhead Indirect labor- Setup costs (@40%) $3,041.83 $779.47 $3,467.68 $0.00 $7,289.0Indirect labor - Handling Production Runs (@50%) $3,333.33 $3,416.67 $2,533.33 $0.00 $9,283.3Indirect labor - Maintaining records(@10%) $500.00 $500.00 $500.00 $0.00 $1,500.0Fringe Benefits (40% of direct) $4,000.00 $3,280.00 $720.00 $0.00 $8,000.00Fringe Benefits (40% of indirect) $2,750.06 $1,878.45 $2,600.41 $0.00 $7,228.92Computer Systems - Handling Production Runs $2,666.67 $2,733.33 $2,026.67 $0.00 $7,426.67

Computer Systems - Maintaining Records $500.0 $500.0 $500.0 $0.0 $1,500.00

Machinery Depreciation (Proportion to volume) $4,000 $3,280 $720 $0 $8,000Machine Maintainence (Propotion to volume) $2,000 $1,640 $360 $0 $4,000

Energy (Propotion to volume) $1,000 $820 $180 $0 $2,000

Total Overhead $23,791.89 $18,827.92 $13,608.09 $0.00 $56,227.90

Total Variable Costs $58,791.89 $47,527.92 $20,088.09 $0.00 $126,407.90Total operating Income/ Contribution $16,208.11 $13,972.08 $2,411.91 $0.00 $32,592.10Return on sales/ Contribution Margin 21.61% 22.72% 10.72% 0.00% 20.50%

Our Recommendation

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• 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)• 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.

Any Questions?