The case study (slightly modified) is from the text book of Kaplan, R.S. & Atkinson, A.A. (1998) Advanced Management Accounting (Third Edition) Prentice Hall, New Jersey, pages 113-116. The case study is presented below:

The Modern Pen Company.

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.

But Hayvice 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 seen 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 Denniss advice and introduce even more specialty colored pens. Dennis claims that consumers are willing to pay higher prices for these speciality colours.

other parts are pasted in next posted question

Jeffery Donald, the manufacturing manager, was also reflecting on the changed environment at Modern 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 colour, and then start the production of the red ink. Making black ink was simple; we didnt 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 rumours I keep hearing that even more new colours may be introduced in the near future. I dont think we have any more capability to handle additional confusion and complexity in our operations.

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.