DEVELOPING AN ABC MODEL
Assignment Brief
CLASSIC PEN CO.: DEVELOPING AN ABC MODEL
Questions:
- Calculate the revised Products costs for the four pens, based on the activity information collected by Dernpsey
- What actions are stimulated by the ABC product costs?
Sample Answer
Classic Pen Co.: Developing an ABC Model
Introduction
Classic Pen Co. faced increasing competitive pressure and a growing demand for product variety. While customers were attracted to different colours and designs, the company relied on a traditional costing system that spread overheads broadly across all products. This distorted the real cost of producing each type of pen, because activities such as setups, purchasing, packaging, and material handling were not consumed evenly. To address this issue, Dempsey introduced Activity-Based Costing (ABC), which reallocates overhead costs to the products based on their actual use of activities. The following analysis explains how the revised product costs are calculated and what actions managers should take once these costs are revealed.
Calculating Revised Product Costs under ABC
Activity-Based Costing calculates product costs in a more detailed manner than traditional systems. Instead of assigning overheads as a flat rate, ABC recognises that different products demand different amounts of support activities.
The calculation begins by determining the rate for each cost driver. This is done by dividing the total cost of an activity pool by the total quantity of the driver. In plain terms:
Driver rate = Total activity cost ÷ Total quantity of driver.
Once these rates are established, each product is charged according to the activities it consumes. For example, if the setup cost pool is £50,000 and there are 500 setups in total, the rate is £100 per setup. A pen that requires 20 setups would then be charged £2,000 for setups. This process is repeated for all relevant activities, such as purchase orders, material moves, inspections, packaging runs, and machine time.
The total activity cost assigned to each pen is calculated by multiplying the driver rate by the pen’s usage of that activity and summing the results across all activities. In formula form:
Total activity cost for a product = Sum of (Driver rate × Product’s driver usage).
Finally, the revised unit cost for each pen is obtained by adding direct materials, direct labour, and the assigned activity costs, and then dividing by the number of units produced. The expression can be written as:
Revised unit cost = (Direct materials + Direct labour + Total activity cost) ÷ Units produced.
By following these steps with Dempsey’s activity data, Classic Pen can calculate more accurate unit costs for the four pens. In practice, this typically reveals that high-volume, standard pens have been over-costed under the old system, while low-volume or special-colour pens have been under-costed.
Interpretation of ABC Results
The revised costs provide an important insight into product profitability. Standard pens, which are produced in large batches and consume relatively few setups or packaging runs, often turn out to be cheaper than previously reported. By contrast, pens in special colours or smaller batches require a disproportionate amount of setups, purchase orders, and handling, which raises their true cost.
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