Assignment # 2

Classic Pen Company: Developing an ABC Model

Submitted by:
Abdullah Inayatullah
Ahsan Iqbal
MBA

3.5 Years (Finance)

Submitted to:
Sir Naveed Mughal

Introduction:

12123025
12123019

The classic pen company shift its product mix from high volume standard products to include
low volume speciality products. Its overhead cost will rise to accommodate the more complex
demands being made on the factory but a conventional cost system will allocate much of the
increased overhead costs to the high volume standard products.
Analysis
Run machine is a unit related activity. The quantity of the activity was proportional to the
total number of pens produced. Production runs and setup machines are batch related. The
quantity demand is proportional to the number of batches runs. The demand for the activity
expands with the number of different products produced in the factory but is independent of
the production volumes. The Fringe benefits activity is best viewed as a support activity for
the four new activities plus direct labour. Its expense can be spread back to these five
activities as a percentage mark-up over direct and indirect labour expense within each
activity.
Classis Pen Company Model:

Activates

Drivers

Outputs

Handle
Prod,
Runs

Set Up
Time

Parts
Admin

Machine
Support

Direct
Labour
Fringe

Productio
n Runs

Set Up
Hours

Number
of Parts

Machine
Hours

Direct
Labour $

Blue Pens

Activity Based Product Profitability:

Black
Pens

Red Pens

Purple
Pens

The activity based cost and profitability of the four products shown below. The profitability
of Classic Pen was decreasing in recent years.
The two speciality products which the previous cost system had reported as the most
profitable are in fact highly unprofitable.
To produce these new products the company has added large quantity of overhead resources,
a large computer system and many more indirect and support employee to enable these
products to be designed and produced. The high expense of these additional resources has not
been compensated by the revenue from the sale of Red and Purple pens.
The activity based analysis shows that contrary to the perspective of the traditional system.
The blue and Black pens are the only profitable products made by Classic Pen. These
products retain 20% profit margin that the company had enjoyed before the new speciality
products had been introduced.
Activites:
Handle

Set

Up Admin

Run

Total

Production runs

Machine

Parts

Machine

Expense

50%
80%

40%

10%
20%

$28000
10000

100%
100%
100%
$4800
$14000
4
10000%
No
of Machine

8000
4000
2000
$52000

Indirect labour &

1/2 fringe
Computer expense
Machine

depreciation
Maintenance
Energy
Activity expense
$22000
Cost driver activity 150
units
of

$11200
526

measurements
Production runs
Activity cost driver
rate
$147
ABC Income Statement:
Blue
Sales
75000
Material cost
25000
Direct labour
10000
40% fringe of D.L
4000
Machine time expense 7000

Black
60000
20000
8000
3200
5600

setup hours

parts

hours

$21

$1200

$1.40

Red
13950
4680
1800
720
1260

Purple
1650
550
200
80
140

Total
150600
50230
20000
8000
14000

Production

run

expense
setup time expense
Admin parts expense
Total expense
Operating income
Return on sales

7333
4259
1200
58792
16208
21.60%

7333
1065
1200
46398
13602
22.70%

5573
4855
1200
20088
-6138
-44%

1760
1022
1200
4952
-3302
-200%

21999
11201
4800
130230
20370
13.50%

Recommendations:
Jeffrey Donald and his manufacturing people should try to run their production
equipment faster. They should improve the performance of unit level activities.
Donald should reduce the setup time by improving the performance of batch level
activities. So that small batch of the speciality products would be less expensive to
produce.
Alternatives:
Pricing, process improvement and engineering and design improvement would significantly
increase Classic Pens profitability without compromising its ability to compete in both the
high volume Blue and Black pen markets.