Managerial Accounting – Classic Pen Company Case 09/04/2013 Archana Mohan Deepak Shivamurthy Gurpreet Singh Krishnamma Muniswamy Manohar Rao Padmesh Mishra Rahul Ravikanth Robin Scaria Satya Peesapati Subrat Sahu GMITE7- Group 7

Key Topics Case Background? -5 min Key Questions we need to answer – 1 min Why is Traditional Costing wrong – 2 min Activity Based Costing – 8 min Inference/Observations/Recommendations – 8 min Any questions? 1-2 min

Case Background

What’s the background? Classic pen company had been the low cost producer of BLUE and BLACK Pens. Profit margins of over 20% of sales. Introduced Red pens 5 years back, as technology required was same, and premium of 3% could be charged. Last year introduced purple pens with premium of 10%. All pens use same technology and production facility. Overheads burden rate increased from 200% to 300% with introduction of the new colors.

Issues highlighted in the case? Red and Purple pens seems profitable, but overall profitability is down Is this due to tougher competition or something else? Purple pens are showing higher margins, so should we introduce more colors? Are consumers willing to pay more prices for special colors?

Key Questions we need to answer

Key Questions we need to answer? By introducing more colors with premium in selling price, profitability is down. Is my cost analysis right? Calculate the revised product costs for the four pens based on activity information collected. What actions are stimulated by the ABC product costs?

Why is traditional costing wrong?

Traditional Income Statement Blue 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 Overhead @300% $30,000 $24,000 $5,400 $600 Total Operating Income $2,070 $300 $20,370 Return on Sales (Contribution Margin) 13.3% 14.8% 18.2% 13.5% Why is above costing wrong? Excerpts from Manufacturing Manager: More change overs with introduction of low volume colored pens Lots of time taken to stop production, empty vats, clean previous color Demanding specifications for Red and Purple, as compared with Blue and Black. Lot of time spent in purchase, scheduling and keeping track of existing, backlogged and future orders. New computer system introduced due to new colors, but cost is attributed to all colored pens equally. TI operating expense is high Salaries Rents Utility bills Interest payments Retiral benefits Supplier costs

Why is above costing wrong? All indirect expenses are aggregated and allocated to products based on their direct labor content. Above seems to be the MISTAKE, as there’s a lot of over head expenses introduced with RED and PURPLE pens, but cost is distributed equally against all 4 products @ 300% of the direct labor. Solution? Need to calculate actual costs and allocate that against each of the products? Derive next steps based on the new cost analysis? TI operating expense is high Salaries Rents Utility bills Interest payments Retiral benefits Supplier costs

Activity Based costing

Over Head Expenses Categorized Expense Category Expense Comments Indirect labor $20,000 50%: Scheduling and handling production runs 40%: Physical changeover for color change 10%: Maintaining records Fringe Benefits $16,000 40% of labor expenses (direct(20k) and indirect(20k)) Computer Systems $10,000 80% involved in production run activity 20% keep records for four products Machinery Depreciation $8,000 Practical capability of 10000 hours Based on volume or machine hours Machine Maintainence $4,000 Based on volume or machine hours Energy $2,000 Total $60,000   TOTAL OVERHEAD EXPENSES IN CURRENT SETUP TI operating expense is high Salaries Rents Utility bills Interest payments Retiral benefits Supplier costs Ok, now we know where are these overhead expenses going Next step would be to calculate production runs, setup time, administration time for the current volumes of the colored pens, and allocate costs accordingly.

Direct cost and activity cost drivers Blue Black Red Purple Total Production Sales Volume (numbers) 50000 40000 9000 1000 100000 Unit selling price $1.5 $1.6 $1.7   Direct Material Costs $25,000 $20,000 $4,680 $550 $50,230 Materials unit cost $0.50 $0.52 $0.55 Direct Labor $10,000 $8,000 $1,800 $200 Direct labor hrs/unit 0.02 2000 Direct labor unit cost $10 Machine hours/unit 0.1 Machine hours 5000 4000 900 100 10000 Parts administration 1 4 Setup time/run 6 Production quantity/run 800 236.84211 83.333333 Total Setup time (hours) 200 50 228 48 526 Production Runs 38 12 150 TI operating expense is high Salaries Rents Utility bills Interest payments Retiral benefits Supplier costs Expenses in Green: These are the direct expenses, and increase/decrease in proportion to the volume. Expenses in Red: These are the one that determine overhead expense allocation based on setup time, production runs and parts administration. The ones in black are per unit expenses, and used to calculate total expenses based on volume

Activity based costing Blue Black Red Purple Total Number of units 50000 40000 9000 1000 100000 Sales $75,000 $60,000 $13,950 $1,650 $150,600 Direct Material Costs $25,000 $20,000 $4,680 $550 $50,230 Direct labor Costs($10 per hour) $10,000 $8,000 $1,800 $200 Overhead   Indirect labor- Setup costs (@40%) $3,041.83 $760.46 $3,467.68 $730.04 $8,000.0 Indirect labor - Handling Production Runs (@50%) $3,333.33 $2,533.33 $800.00 $10,000.0 Indirect labor - Maintaining records(@10%) $500.00 $2,000.0 Fringe Benefits (40% of direct) $4,000.00 $3,200.00 $720.00 $80.00 $8,000.00 Fringe Benefits (40% of indirect) $2,750.06 $1,837.52 $2,600.41 $812.02 Computer Systems - Handling Production Runs $2,666.67 $2,026.67 $640.00 Computer Systems - Maintaining Records $500.0 $2,000.00 Machinery Depreciation (Proportion to volume) $4,000 $3,200 $720 $80 Machine Maintainence (Propotion to volume) $2,000 $1,600 $360 $40 Energy (Propotion to volume) $1,000 $800 $180 $20 Total Overhead $23,791.89 $18,397.97 $13,608.09 $4,202.05 $60,000.00 Total Variable Costs $58,791.89 $46,397.97 $20,088.09 $4,952.05 $130,230.00 Total operating Income/ Contribution $16,208.11 $13,602.03 -$6,138.09 -$3,302.05 $20,370.00 Return on sales/ Contribution Margin 21.61% 22.67% -44.00% -200.12% 13.53% TI operating expense is high Salaries Rents Utility bills Interest payments Retiral benefits Supplier costs

Total variable cost per unit (ACTIVITY BASED COSTING METHOD) Per Unit Contribution Blue Black Red Purple Unit Selling Price $1.50 $1.55 $1.65 Materials Unit Cost $0.50 $0.52 $0.55 Direct Labor/unit $0.20 Overhead cost/unit $0.48 $0.46 $1.51 $4.20 Total variable cost per unit $1.18 $1.16 $2.23 $4.95 Contribution per unit $0.32 $0.34 -$0.68 -$3.30 Oops!!! Blue Black Red Purple Total Return on Sales (TRADITIONAL METHOD) 13.3% 14.8% 18.2% 13.5% Return on sales (ACTIVITY BASED COSTING METHOD) 21.61% 22.67% -44.00% -200.12% 13.53% TI operating expense is high Salaries Rents Utility bills Interest payments Retiral benefits Supplier costs

What did we learn? Contribution margin of Purple Pens is the worst @ -200%. Increasing volumes will hurt more. Contribution margin of Red Pens is also negative @ -44%. Increasing volumes will hurt more, unless price is adjusted. Contribution margins of Black and Blue pens stands tall @ 22%, against 13% as suggested by traditional method. Company is making losses of around $10,000 by producing Red and Purple Pens, due to huge overhead costs, and incorrect pricing. TI operating expense is high Salaries Rents Utility bills Interest payments Retiral benefits Supplier costs

Recommendations

Option 1: Eliminate “Red” and “Purple” and increase Black by 9k units Blue Black Red Purple Total Number of units 50000 100000 Sales $75,000 $0 $150,000 Direct Material Costs $25,000 $50,000 Direct labor Costs($10 per hour) $10,000 $20,000 Overhead   Indirect labor- Setup costs (@40%) $3,041.83 $950.57 $0.00 $3,992.4 Indirect labor - Handling Production Runs (@50%) $3,333.33 $4,166.67 $7,500.0 Indirect labor - Maintaining records(@10%) $500.00 $1,000.0 Fringe Benefits (40% of direct) $4,000.00 $8,000.00 Fringe Benefits (40% of indirect) $2,750.06 $2,246.89 $4,996.96 Computer Systems - Handling Production Runs $2,666.67 $6,000.00 Computer Systems - Maintaining Records $500.0 $0.0 $1,000.00 Machinery Depreciation (Proportion to volume) $4,000 $8,000 Machine Maintainence (Propotion to volume) $2,000 Energy (Propotion to volume) $1,000 Total Overhead $23,791.89 $22,697.47 $46,489.35 Total Variable Costs $58,791.89 $57,697.47 $116,489.35 Total operating Income/ Contribution $16,208.11 $17,302.53 $33,510.65 Return on sales/ Contribution Margin 21.61% 23.07% 0.00% 22.34% TI operating expense is high Salaries Rents Utility bills Interest payments Retiral benefits Supplier costs

TI operating expense is high Option 2: Eliminate “Purple” and increase Black by 1k units, Retain Red but increase price from $1.6 to $2.5 to make contribution margin > 0 Blue Black Red Purple Total Number of units 50000 41000 9000 100000 Sales $75,000 $61,500 $22,500 $0 $159,000 Direct Material Costs $25,000 $20,500 $4,680 $50,180 Direct labor Costs($10 per hour) $10,000 $8,200 $1,800 $20,000 Overhead   Indirect labor- Setup costs (@40%) $3,041.83 $779.47 $3,467.68 $0.00 $7,289.0 Indirect labor - Handling Production Runs (@50%) $3,333.33 $3,416.67 $2,533.33 $9,283.3 Indirect labor - Maintaining records(@10%) $500.00 $1,500.0 Fringe Benefits (40% of direct) $4,000.00 $3,280.00 $720.00 $8,000.00 Fringe Benefits (40% of indirect) $2,750.06 $1,878.45 $2,600.41 $7,228.92 Computer Systems - Handling Production Runs $2,666.67 $2,733.33 $2,026.67 $7,426.67 Computer Systems - Maintaining Records $500.0 $0.0 $1,500.00 Machinery Depreciation (Proportion to volume) $4,000 $3,280 $720 $8,000 Machine Maintainence (Propotion to volume) $2,000 $1,640 $360 Energy (Propotion to volume) $1,000 $820 $180 Total Overhead $23,791.89 $18,827.92 $13,608.09 $56,227.90 Total Variable Costs $58,791.89 $47,527.92 $20,088.09 $126,407.90 Total operating Income/ Contribution $16,208.11 $13,972.08 $2,411.91 $32,592.10 Return on sales/ Contribution Margin 21.61% 22.72% 10.72% 0.00% 20.50% TI operating expense is high Salaries Rents Utility bills Interest payments Retiral benefits Supplier costs

Our Recommendation Choose Option 1, if price of RED is competitive and can’t be increased. Gives maximum return of 22.34%. Setup and processes are efficiently utilized, so overheads are less Only issue is that company will loose it’s diversity of product by shutting down RED and PURPLE. Choose Option 2, if price of RED can be played with. Gives good return of 20.5%. Setup and processes are not that efficiently utilized, but overheads due to RED are absorbed in it’s premium price. Some diversity of product will remain (BLACK, BLUE and RED) TI operating expense is high Salaries Rents Utility bills Interest payments Retiral benefits Supplier costs Other recommendations. Using same facility for colored pens doesn’t make sense. Company should setup a new facility for RED and PURPLE Pens, in case fixed costs are justified. This will reduce overhead costs of setups(change color). In case company retains RED, it can introduce Bundle offer to boost sales. For example Blue(1.18) + Red(2.23) bundle minimum for Rs 3.41, etc.

Any Questions?