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Activity-based cost systems Case: The classic pen company Classic pen company Facts: Low-cost producer of traditional BLUE and BLACK pens Profit margin: over 20% of sales Declining trend in operating results Opportunity for adding new products: 1. Red pen introduced five years before with same technology at 3% premium 2. Purple pen introduced with 10% premium last year Issues before management • Premium products (Red & Purple) more profitable, but overall profitability is down • Even new products’ margin declining in face of competition • Introduction of new pens requires: more activities (more resources?) More set-up time (max. for red pen) More purchasing and scheduling time Present cost system Features: • Single overhead absorption rate • Direct labour cost is the base • Rate is 300% of DLC • Previously it was 200% (indicates increase in indirect expenses) Traditional cost sheet Blue Black Red Purple Total DM 25000 20000 4680 550 50230 DL 10000 8000 1800 200 20000 OH (300% 30000 24000 5400 600 60000 of DL) Total cost 65000 52000 11880 1350 130230 Sales 75000 60000 13950 1650 150600 Operating 10000 8000 2070 300 20370 income Margin 13.3 13.3 14.8 18.2 13.5 (%) ABC • Overhead is not a burden to be allocated on top of direct labour • Identify activities of indirect and support resource of the entity • Relate the cost of these activities to the products for which they are performed Condition: large overhead (46% of TC) and multiple products – may be ABC would help ABC Analysis Expenses identified: Rs. Indirect labour 20,000 Fringe benefits 16,000 Computer Systems 10,000 Machinery 8,000 Maintenance 4,000 Energy 2,000 Total 60,000 Forming cost pools Indirect labour Rs. 20,000 + 40% of fringe benefit, i.e., Rs.8,000 = Rs.28,000 Computer expenses Rs.10,000 Machine expenses Rs.8,000+Rs.4,000+Rs.2,000 =Rs.14,000 Activities identified Scheduling or handling production runs Production set up Record keeping Machine support Relating activities to activity drivers Activities Activity drivers Handling production runs Production runs (150 nos.) Production set up Setup time (526 hours) Record keeping No. of products (4) Machine support Machine hours (10,000hr) Allocation of cost to activities Indirect % share Comp. % share Machine % share Total labour expenses expenses Handling 14,000 50% 8,000 80% 22,000 Productio n run Prod. set 11,200 40% 11,200 up Record 2,800 10% 2,000 20% 4,800 keeping Machine 14,000 100% 14,000 support Total 28,000 10,000 14,000 52,000 New cost system-ABC Blue Black Red Purple Total DM+DL 35,000 28,000 6,480 750 70,230 Fringe benefit 4,000 3,200 720 80 8,000 Overheads Handling prod. Run 7,333 7,333 5,573 1,760 22,000 Prod. Set up 4,259 1,065 4,855 1,022 11,200 Record keeping 1,200 1,200 1,200 1,200 4,800 Machine support 7,000 5,600 1,260 140 14,000 Total overhead 19,792 15,198 12,888 4,122 52,000 Total cost 58,792 46,398 20,088 4,952 130,230 Sales 75,000 60,000 13,950 1,650 150,600 Profit 16,208 13,602 -6,138 -3,302 20,370 Profit margin(%) 21.6 22.7 -44 -200.1 13.5 Comparison of OH share Traditional cost system ABC system Blue - 30,000 Blue - 19,792 Black -24,000 Black – 15,198 Red - 5,400 Red -12,888 Purple - 600 Purple – 4,122 Comparison of Margin Traditional cost system ABC system Blue - 13.3% Blue - 21.6% Black – 13.3% Black – 22.7% Red - 14.8% Red - (-44%) Purple - 18.2% Purple – (-200.1%) Conclusion Addition of new products has resulted in increase of overheads New product mix means disproportionate demand on resources of the organisation due to unequal activity content that goes into different products ABC can result in more accurate costing in such cases