Crazy Crayon Inc. had been the low-cost producer of traditional BROWN crayons and BLACK crayons, and had enjoyed gross margins over 15% of sales. Several years earlier, the company had seen opportunities to expand the business by extending the product line into new specialty products that earned premium selling prices. Two years earlier PURPLE crayons had been introduced, which required the same basic production technology but could be sold at 10% premium. And last year RED crayons had been introduced because of the even higher price premium they could command.

Operations: Crazy Crayon Inc. produced all crayons in a single factory plant. The major task was preparing and mixing the wax mixtures for the different colored crayons. The wax was inserted into one of the two crayon molding machines leased from an outside supplier in a semi-automated process. A final packing and shipping stage was performed manually.Each product had a bill of materials and a routing sheet that identified the cost of direct materials and direct labor. All of the plants indirect expenses were aggregated and allocated to products based on their direct labor costs. Currently this overhead rate was 242% of direct labor cost. Most people in the plant recalled that not too many years ago the overhead rate was less than 100%.

Question 1:

If Crazy Crayons Inc. assigns overhead costs using the direct labor as the cost driver and the overhead rate of 242%, how much overhead will be allocated to each type of crayon? What is the gross margin ratio for each of type of crayon?

Marc Johnson, president and chief executive officer of Crazy Crayon Inc., was keenly disappointed by the financial results for the most recent fiscal year. He is particularly concerned about the declining profit margins of the traditional BROWN-crayon and BLACKcrayon line of business. He called a meeting and summarized the situation by saying,

Perhaps this is the tougher global competition I have been reading about. I think that some of our foreign competitors specialized in making BLACK and BROWN crayons are dumping their products in the U.S. market, driving down prices and unit sales. At least the new specialty lines, particularly RED crayons, are showing much higher margins. Perhaps we should introduce even more specialty colored crayons. Our sales manager claims that consumers are willing to pay higher prices for these specialty colors.

Eric Myerson, Crazy Crayons controller said,

Marc, as you know, our current accounting system allocates all overhead costs, including setup time and machining costs, to the four product lines based on direct labor hours. I have become worried that our overhead rate is getting out of control. I am thinking we should refine our accounting system. To get a more accurate estimate of our product costs, we should break out machining costs separately from the general overhead and assign them to each product using machine hours.

Jeffrey Donald, the manufacturing manager, was also reflecting on the changed production environment:

Two years ago, life was a lot simpler. We produced just BROWN and BLACK crayons in long production runs, and everything ran smoothly, without much intervention. Making black crayons was especially simple; we didnt even have to clean out the residual BROWN wax from the previous run if we just dumped in enough black wax to cover it up.

Difficulties started when the RED crayons were introduced, because even small traces of the BROWN or black wax in the mold would created quality problems. This required us to stop production and clean out all remnants of the previous color from the mold. The wax for the PURPLE crayons also has demanding specifications, but not quite as demanding as for RED crayons.

Because the RED crayons and PURPLE crayons are often ordered in small and unpredictable order sizes, we seem to be spending a lot more time on purchasing and scheduling activities and just keeping track of where we stand on existing, backlogged, and future orders. I am concerned about rumors I keep hearing that even more new colors maybe introduced. I dont think we have any more capability to handle additional confusion and complexity in our operations.

Karen Choddack, an outside director on the board and an economist asked,

I dont pretend to know a lot about the crayon business, but how confident are you in your cost data? If I were you, I would not attempt to allocate the shared overhead. Dont you remember the Parable of the Red Pens and Blue Pens?

Question 2:

How would you respond to Karens argument that Crazy Crayon Inc. should not attempt to allocate shared overhead? Would the costing system proposed by Mr. Myerson greatly improve the accuracy of the product costs?

Activity Based Costing:

In searching for a clear answer, Marc Johnson recently attended a seminar on a new concept called Activity Based Costing. Following the suggested steps of setting up an ABC system, Johnson first identified four categories of support expenses that were currently being allocated to crayon production. He determined that the fringe benefits were 25% of labor expenses (both direct and indirect) and would thus represent just a percentage markup to be applied on top of direct and indirect labor charges. The table below provides the monthly expense categories and amounts.

Crazy Crayon had seven production employees who did both the actual work of producing the crayons as well as all of the production support work. The costing system treated the employees as direct labor when they ran the production process and indirect when they did everything else such as setting up a machine from one production run to the next, scheduling production runs, ordering and receiving raw materials, and maintaining records on the various products. Johnson interviewed these employees and found that three main activities accounted for their support work, with the following estimates on the percentages of time spent on the three activities:

• Scheduling production runs (30%) includes scheduling production orders, purchasing, preparing, and releasing wax materials for the production run.
• Setting up production runs (60%) refers to the physical changeover from one color crayon to another. Three employees worked as a team to perform each changeover. The time to change over to BLACK crayons was relatively short (about 1 hour) since the previous color did not have to be completely eliminated from the molding machine. Other colors required longer changeover times; RED crayons required the most extensive changeover to meet the demanding quality specification for this color.
• Maintaining the four products (10%) includes maintaining the bill of materials and routing information, monitoring a minimum supply of raw materials and finished goods inventory for each product, and improving the production processes.

The remaining two categories of overhead expense (lease payment and energy to operate the machines) were primarily incurred to supply machine capacity to produce the crayons.

Table 2 below provides information on potential activity cost drivers of Crazy Crayons activities for each of the four products.

Question 3:

a. Complete the following table of stage I allocation. First, in the row immediately below activities, fill in the major activities that consume the indirect cost. Second, for each indirect cost item (rows 3-5), separate the cost into activity cost pools. Lastly, in rows 6-8, for each activity, calculate the total costs, identify an appropriate cost driver, and compute the cost driver rate.

b. Complete the table of Stage II allocation in the attached Excel file. If Crazy Crayon Inc. assigns overhead costs using the cost drivers in the table, how much overhead will be allocated to each product line? How much is the gross margin ratio for each product line?

Table 1: Basic product Information for a typical month Units Produced and Sold Unit Selling Price Materials cost per unit Direct labor cost per unit Machine hours per unit BROWN 10,000 $3.00 $0.60 $0.70 0.011 BLACK 8,000 $3.00 $0.60 $0.70 0.011 PURPLE 1,200 $3.30 $0.60 $0.70 0.011 RED 800 $3.50 $0.65 $0.70 0.011 Units produced and sold Number of production runs Setup time for each production run Number of products Total machine hours BROWN 10,000 12 2 1 110 BLACK 8,000 12 1 1 88 PURPLE 1,200 8 2.5 1 13 RED 800 6 4 1 9 Expense Category Indirect Labor Fringe Benefits (25% of direct and indirect labor) Lease of machinery Energy Expense $12,000 $6,500 $14,000 $1,400 Table 1: Basic product Information for a typical month Units Produced and Sold Unit Selling Price Materials cost per unit Direct labor cost per unit Machine hours per unit BROWN 10,000 $3.00 $0.60 $0.70 0.011 BLACK 8,000 $3.00 $0.60 $0.70 0.011 PURPLE 1,200 $3.30 $0.60 $0.70 0.011 RED 800 $3.50 $0.65 $0.70 0.011 Units produced and sold Number of production runs Setup time for each production run Number of products Total machine hours BROWN 10,000 12 2 1 110 BLACK 8,000 12 1 1 88 PURPLE 1,200 8 2.5 1 13 RED 800 6 4 1 9 Expense Category Indirect Labor Fringe Benefits (25% of direct and indirect labor) Lease of machinery Energy Expense $12,000 $6,500 $14,000 $1,400