Problem Statement:

The Traditional Absorption Costing method used at the Classic Pen Company was supposed to be an
inaccurate representation of the product cost and return of sales. As it operates with a single cost
centre i.e. based on a single driver, to allocate overhead costs, it could lead to product cost
distortion. Even if it used multiple cost centres, it could still encounter severe distortions in reported
product cost. As all pens have roughly the same complexity, each pen would require similar number
of machine hours and direct labour hours to produce. Therefore, on a per unit basis, high volume
standard black and blue pens would require about the same amount of direct labour cost as the low
volume red and purple colour pens. Therefore, the traditional costing method would report identical
product costs for all products, whether standard or speciality, irrespective of their product volumes.
This leads to the cost distortion.
The assessment of profitability of each pen has to be carried out based on the cost of each activity
with resources to all pens, standard or speciality, based on actual consumption by each. In addition
to this, assessment of viability of introducing new speciality coloured pens has to be done.

Purpose statement:
The costs and profits of existing pen lines are to be analysed on the basis of more accurate activity
based costing (ABC). This will help in identifying actual price incurred by each pen and thereby
eliminating those which are unprofitable. Moreover, the comparison of the costs and profits of
activity based costing and tradition absorption costing can be carried out.
Scope:
Traditional absorption costing helps to determine the overall profitability or efficiency of the
manufacturing system but does not provide the real cost of discrete product units. Activity based
costing emulates the functioning of the firm and adds to strategic decision-making processes. In
large firms which deal with multi-product operations, conventional overhead allocation methods like
traditional absorption costing may produce ambiguous results. As a result of this, absorption costing
is more appropriate for small enterprises and firms with homogeneous products or services. Activity
based costing, however, can be applied to the case of multiproduct-operations like manufacturing of
different colour pens by a firm.
Limitations:
It is very difficult to identify all the activities that influence product cost as some overhead costs like
the salary of chief executive are impossible to segregate on the per-product usage basis. Moreover,
this process is costly as well as time consuming as it might require division of costs into several
groups to represent the many activities and requires updating on regular basis. Also, traditional
activity based costing systems do not generally take into account the capacity issues and assume
that all resources are fully engaged at 100 percent in an activity. This makes redeployment analysis
difficult. We have to consider time-driven activity based costing if capacity is a major variable to be
looked into. In addition to these, activity based costing time and again brushes against the corporate
culture by proposing organizational change. Employees may openly question ABCs value, think if
their jobs are at risk, and work against its implementation. Change management is critical in any ABC
implementation.