Management accounting: Wilkerson Company is in the business of manufacturing valves, pumps, flow controllers etc. Severe industry wise price cuts in the pumps business, which is Wilkersons major product line, has badly affected the company
Wilkerson Company is in the business of manufacturing valves, pumps, flow controllers etc. Severe industry wise price cuts in the pumps business, which is Wilkerson’s major product line, has badly affected the company’s margins (Gross Margin of 19.5% as against a planned gross margin of 35%). On the other hand the flow controllers division was performing above the expected profits (yielding a Gross Margin of 41%, a value higher than 35% estimated). Wilkerson needs to identify the proper mix of its product line to regain its profitability. This is to be done based on information provided in the case, regarding pricing decisions, decision to discontinue or continue a product and product design.
A detailed analysis of the problems faced by Wilkerson Company is as follows.
Based on the operating results of March 2000, we see that the company has grouped its overheads into 5 cost items, as below:
- Machine-related expenses
- Setup labor cost
- Receiving and production control
- Packaging and shipment
Current Method - Volume Based Costing
As per the given information, Wilkerson uses volume based costing system. Direct material and labor costs are based standard prices. Overheads are charged as 300% of the direct labor cost. This implies overheads are applied directly in relation to labor costs irrespective of relevance.
Table 1 - Margin Calculation for Volume Based Costing
Based on the volume based costing method we can clearly see that the Valves are performing within the planned margins, while Pumps are performing well below par (Gross Margin of 19.54% against expected 35%) and Flow controllers are performing above par (40.95% against 35%).
Such a costing methodology is adequate in the short run since the decision to accept or reject an order is based on the variable costs associated. However, in the long run, the decision to have a proper product mix is based on the performance and breakeven point of each product. Moreover since overheads are very high, they are significant contributors to decision making in this costing method. But they might end up giving unreliable information during decision making since in this method we directly relate the overheads to the products on the basis of percentage of product run direct labor cost. This method is not reliable since each product varies significantly in its overheads costs association and the basic assumption that a direct relation exists is wrong.
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Proposed Method - Activity Based Costing
Going forward, based on these groups, the company should choose the most appropriate cost drivers that reflect the relationship between the volume of production of individual products and the level of overheads. It can be said that ‘machine hours’ is the appropriate cost driver for the machine-related expenses cost pool and setup and receiving as well as production control activities are changed in proportion to number of production runs. Engineering cost is driven by hours of engineering work and lastly packaging and shipment activity changes in proportion to the number of shipments. These are mostly based on the information given in the study which was carried out by the group
Table 2 – Cost Pools, Drivers and Rates
Table 2 presents us with the information about the various activities on which we have based the costing basically the cost pools, drivers of the relevant cost pools and the rate of the costing which should be taken into account. As an example we can see in the Table 2 we have one of the cost pools as Machine Related Expenses. Based on the information in exhibit 1 regarding the distribution of operating overheads costs we see that the overhead expenses in this category is $336000, also from the study carried out and the first point mentioned it was found that the driver for this pool was the number of machine hours which is 11200 hours. Based on this information the costing rate for this pool was calculated as $30 per hour which will enable us to do the activity based costing in the next stage.
Table 3 – Product wise Activity Based Costing
In order to carry out an activity based costing so that we can find the relevant costs associated with each product we do the product wise activity based costing for the individual cost pools (in table 3) which were defined in table 2. Exhibit 4 provides us with the data relating to the monthly production and operating statistics which can be combined with the costs for each cost pool derived in table 2 to give us the individual product wise activity based costing.
Table 4 - Per Unit Activity Based Costing
The data obtained from table 3 enables us to arrive at table 4 which calculates the per unit activity based costing taking into account the total cost for each activity and the number of units produced of each product to get the individual product wise per unit costs. The total cost of each unit will be the sum of the direct costs (direct labor and direct material) and the activity based costs (machine related, setup labor, receiving and production, engineering and shipping costs). This total cost of each product will enable us to calculate the margins that each product provides based on the planned as well as the actual selling prices. This information is provided in table 5 as shown below.
Table 5 - Margin Calculation for Activity Based Costing
With the help of Activity Based Costing, the company can analyze and infer information about its products more accurately and better evaluate the financials and gross margins. In the table 5 margin information and the excel sheet attached we can see that flow controllers appear to be less attractive with negative margins as compared to other 2 products – valves and pumps.
The Company can still decrease the prices of valves and pumps and be comparable to the industry to sustain the market position whereas in case of flow controllers the company is already operating at a negative gross margin and needs to increase the price if the product is to provide sustainable profits.
Shortcomings of Analysis
We have assumed average unit cost for individual flow controllers. Calculations are done for a sample month in terms of capacity utilization. Costs of resources are assumed to be constant over a given time. Administrative expenses are not taken into consideration while performing the calculations. Also, we have not considered that the resources are not being completely utilized and that the production has gone up to using 12000 machine hours, 180 production runs and 400 shipments the previous year without any additional overtime expenses or production delays.
Based on our analysis of the 2 costing methods, we recommend that Wilkerson company move from volume based costing to activity based costing to better analyze the cost figures and health of the company. It will enable the overheads to be attached to the products and activities where they are being consumed and not directly be related to the products on the basis of production run direct labor hours. Also as can be seen from the analysis of the 2 methods the gross margin returns vary wildly in both the cases. The clear indicator of that is the flow controller that the company manufactures. Volume based costing indicates that the product is highly profitable providing a gross margin of 40.95% whereas the activity based costing shows us that flow controllers are not providing any returns and on the contrary it is a loss making product since we are unable to recover even the costs involved.
We recommend the company to review its policy in respect to flow controllers. Wilkerson can work on changing the prices of individual flow controllers in order to secure a healthy profit margin. One way to do this is setting prices in accordance with the amount of resources consumed (activity-based pricing) by individual product or customer. Even if this is cumbersome they should at least review the current prices of the flow controller as they are costing the company more to produce these items than the selling price of the product. Also it was noticed that a price rise of 10% for the flow controllers did not have any effect on the sales of the product and there is sufficient scope to increase the price of the product more.
The company can also consider few actions that might reduce the cost of flow controllers. For instance, change design, eliminate waste of resources and delivery to decrease the cost per unit associated with production runs and number of shipments.