Jane Hayvice, controller of the Modern Pen Company, was concerned about the recent financial trends in operating results. Modern Pen had been the low-cost producer of traditional BLUE pens and BLACK pens. Profit margins were over 20% of sales.

Several years earlier Dennis Smith, the sales manager, had seen opportunities to expand the business by extending the product line into new products that offered premium selling prices over traditional BLUE and BLACK pens. Five years earlier, RED pens had been introduced; they required the same basic production technology but could be sold at a 3% premium. And last year, PURPLE pens had been introduced because of the 10% premium in selling price they could command.

Operations

Modern produced pens in a single factory. The major task was preparing and mixing the ink for the different-coloured pens. The ink was inserted into the pens in a semiautomated process. A final packing and shipping stage was performed manually.

Each product had a bill of materials that identified the quantity and cost of direct materials required for the product. A routing sheet identified the sequence of operations required for each operating step. This information was used to calculate the labour expense for each of the four products. All of the plants indirect expenses were aggregated at the plant level and allocated to products on the basis of their direct labour content. Currently, this overhead burden rate was 520% of direct labour cost. Most people in the plant recalled that not too many years ago the overhead rate was only 200%.

Activity-Based Costing

Jane Hayvice had recently attended a seminar of her professional organisations in which a professor had talked about a new concept, called activity-based costing (ABC). This concept seemed to address many of the problems she had been seeing at Modern. The speaker had even used an example that seemed to capture Moderns situation exactly.

The professor had argued that overhead should not be viewed as a cost or a burden to be allocated on top of direct labour. Rather, the organisation should focus on activities performed by the indirect and support resource of the organisation and try to link the cost of performing these activities directly to the products for which they were performed. Hayvice obtained several books and articles on the subject and soon tried to put into practice the message she had heard and read about.

Activity-Based Cost Analysis

Hayvice first identified six categories of support expenses that were currently being allocated to pen production:

EXPENSE CATEGORY	EXPENSE
Indirect labour	$25,000
Fringe Benefits	15,000
Computer systems	10,000
Machinery	9,000
Maintenance	3,000
Energy	3,000
Total	$65,000

She determined that fringe benefits were 40% of labour expenses (both direct and indirect) and would thus represent just a percentage markup to be applied on top of direct and indirect labor charges.

Hayvice interviewed department heads in charge of indirect labor and found that three main activities accounted for their work. About half of the indirect labour was involved in scheduling or handling production runs. This proportion included scheduling production orders: purchasing, preparing and releasing materials for the production run; performing a first-item inspection every time the process was changed over, and some scrap loss at the beginning of each run until the process settled down. Another 40% of indirect labour was required just for the physical changeover from one colour pen to another.

The time to change over to BLACK pens was relatively short (about 1 hour) since the previous colour did not have to be completely eliminated from the machinery. Other colours required longer changeover times; RED pens required the most extensive changeover to meet the demanding quality specification for this colour.

The remaining 10% of the time was spent maintaining records on the four products, including the bill of materials and routing information, monitoring and maintaining a minimum supply of raw materials and finished goods inventory for each product, improving the production processes, and performing engineering changes for the products. Hayvice also collected information on potential activity cost drivers for Moderns activities (see Exhibit 2) and the distribution of the cost drivers for each of the four products. Hayvice next turned her attention to the $10,000 of expenses to operate the companys computer system. She interviewed the managers of the Data Center and the Management Information System departments and found that most of the computers time (and software expense) was used to schedule production runs in the factory and to order and pay for the materials required in each production run.

Because each production run was made for a particular customer, the computer time required to prepare shipping documents and to invoice and collect from a customer was also included in this activity. In total, about 80% of the computer resource was involved in the production run activity. Almost all of the remaining computer expense (20%) was used to keep records on the four products, including production process and associated engineering change notice information.

The remaining three categories of overhead expense (machine depreciation, machine maintenance, and the energy to operate the machines) were incurred to supply machine capacity to produce the pens. The machines had a practical capacity of 10,000 hours of productive time that could be supplied to pen production.

Hayvice believed that she now had the information she needed to estimate an activity-based cost model for Modern Pen.

EXHIBIT 1 Traditional Income Statement

	BLUE	BLACK	RED	PURPLE	TOTAL
Sales	$80,000	$64,000	$13,200	$3,500	$160,700
Material cost	27,500	22,000	4,560	1200	55,260
Direct labour	6,250	5,000	1,000	250	12,500
Overhead @ 520%	32,500	26,000	5,200	1,300	65,000
Total operating income	$13,750	$11,000	$2,440	$750	$27,940
Return on sales	17.19%	17.19%	18.49%	21.43%	17.39%

Exhibit 2 Direct Costs and Activity Cost Drivers

	BLUE	BLACK	RED	PURPLE	TOTAL
Production sales volume (no. of units)	50,000	40,000	8,000	2,000	100,000
Unit selling price	$1.60	$1.60	$1.65	$1.75
Materials/ unit cost	$0.55	$0.55	$0.57	$0.60
Direct labor hr/unit	0.02	0.02	0.02	0.02	2,000
Machine hour/ unit	0.1	0.1	0.1	0.1	10,000
No. of production runs	50	50	38	12	150
Setup time/ run (hours)	4	1	6	4
Total set up time (hours)	200	50	228	48	526
Number of products	1	1	1	1	4

1.Estimate the costs for the four pen products using an activity-based approach.

2.What are the managerial implications from the revised cost estimates?

3. How would you approach the setting up of an activity-based costing system for the business and what behavioural problems do you think you might encounter?