Respond to the following discussion questions based on your analysis of the case:

1. Submit an ABC Income Statement for Classic Pen. Using the new information from the ABC system come up with a proposal on how to deal with the 4 products.
2. What is a recommendation on how to deal with future product introductions now that we have a better understanding about the microeconomic characteristics of the firm.

The Classic Pen Company Case

Jane Dempsey, controller of the Classic Pen Company, was concerned about the recent

financial trends in operating results. Classic 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 Selmor, 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, which

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.

But Dempsey had just seen the financial results (see Exhibit 1) for the most recent fiscal year

and was keenly disappointed.

The new RED and PURPLE pens do seem more profitable than our BLUE and

BLACK pens, but overall profitability is down and even the new products are not

earning the margins, we used to see from our traditional products. Perhaps this is the

tougher global competition I have been reading about. At least the new line,

particularly PURPLE pens, is showing much higher margins. Perhaps we should

follow Dennis' advice and introduce even more specialty colored pens. Dennis

claims that consumers are willing to pay higher prices for these specialty colors.

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

at Classic Pen:

Five years ago, life was a lot simpler. We produced just BLUE and BLACK

Pens in long production runs, and everything ran smoothly, without much

intervention. Difficulties started when the RED pens were introduced, and we had

to make more changeovers. This required us to stop production, empty the vats, clean out all remnants of the previous color, and then start the production of the red ink. Making black ink was simple; we didn't even have to clean out the residual blue ink from the previous run if we just dumped in enough black ink to cover it up. But for the RED pens, even small traces of the blue or black ink created quality problems. And the ink for the new PURPLE pens also has demanding specifications, but not quite as demanding as for RED pens.

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. The new computer system we got last year helped a lot to reduce the

confusion. But I am concerned about rumors I keep hearing that even more new

colors may be introduced in the near future. I don't think we have any more

capability to handle additional confusion and complexity in our operations.

Operations

Classic produced pens in a single factory. The major task was preparing and mixing the ink

for the different colored 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 labor expenses for each of the four

products. All of the plant's indirect expenses were aggregated at the plant level and allocated to

products based on their direct labor content. Currently this overhead burden rate was 300% of direct

labor cost. Most people in the plant recalled that not too many years ago the overhead rate was only

200%.

Activity-Based Costing

Jane Dempsey had recently attended a seminar of her professional organization 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 Classic. The speaker had even used an

example that seemed to capture Classic's 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 labor. Rather, the organization should focus on activities performed by the

indirect and support resource of the organization and try to link the cost of performing these activities

directly to the products for which they were performed.

Dempsey 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

Dempsey first identified six categories of support expenses that were currently being

allocated to pen production:

Expense Category Expense Indirect Labor $20,000 Fringe Benefits $16,000 Computer Systems $10,000 Machinery $8,000 Mainignanco 5/1000 Enorgy $2,000 Total $60,000Blue Black Red Purple Total Sales $75,000 $60,000 $13,950 $1,650 $150,600 Material Costs 25,000 20,000 4,680 550 50,230 Direct Labor 10,000 8,000 1,800 200 20,000 Overhead @ 300% 30,000 24,000 5,400 600 60,000 Total Operating hcome $10,000 $8,000 $2,070 $300 $20,370 Return on Sales 13.6% 13.3% 14.8% 18.2% 13.5% Blue Black Red Purple Total Production Sales Volume 50,000 40,000 9,000 1,000 100,000 Unit Selling Price $1.50 $1.50 $1.65 Materials-unit cost $0.50 $0.50 $0.52 Direct labor 0.02 0.02 0.02 0.02 2,000 Machine 0.1 0.1 0.1 0.1 10,000 Production runs 50 50 38 12 150 Setup time/run 4 6 4 Total setup time 200 50 228 18 526 Parts Administration