Classic Pen
...g to red or purple takes much more time because the vat must be thoroughly cleaned. By allocating overhead by direct labor hours only, this set-up time is ignored. This results in too much overhead being allocated to the traditional black and blue pens and not enough being allocated to the new red and purple pens. Therefore, the new pens appear to be earning a profit when they are actually really causing the company to lose profits. These new pens have cut into the old profit margin of the blue and black pens. The introduction of the new activity based costing system required to separate costs into four activity cost pools: machine hours, scheduling/handling, physical changeover and maintaining records. Expenses were allocated to each pool by percentages so that all the incurred costs could be split up to each product which is responsible for this cost. With the help of this accurate cost allocation, we could calculate an activity rate based on activity cost drivers. The high set-up time for the red and purple pens cause them to have more overhead allocated. Consequently, blue colored pens cost about USD 1,15 each, black pens amounted for USD 1,13, red pens USD 2,44 and purple pens USD 5,68. While the blue and black pens still have their pre-expansion 20% gross margin, the red and purple pens are running at a considerable loss. The additional overhead that these new pens brought with them far outweigh the additional revenue they can provide. The activity-based costing system raises many new issues...