Overview

Case Study Information Costing Analysis

Traditional costing and Activity based costing Implication of Wilkerson case

Conclusion

Information
Business Structure of Wilkerson Company Information about Prices and Costs

Current Issues from Operation

Business structure and Information

Wilkerson Company

Valve
Actual Data
Valves Actual selling price Standard unit costs Actual gross margin (%) $86.00 $56.00 34.9%

Pump

Flow controller
Flow Controller $105.00 $62.00 41.0%

Pumps $87.00 $70.00 19.5%

Target
Valves Target selling price Standard unit costs Target gross margin(%) $86.15 $56.00 35.00% Pumps $107.69 $70.00 35.00% Flow Controller $95.38 $62.00 35.00%

Business structure and Information

Wilkerson Company

Valve
Standard unit costs
Valves Direct Labour cost Direct material cost Manufacturing overhead (@300%) Standard unit costs $10.00 $16.00 $30.00 $56.00

Pump

Flow controller
Flow Controller $10.00 $22.00 $30.00 $62.00

Pumps $12.50 $20.00 $37.50 $70.00

Production
Valves Pumps 4 component 5 components Produced and shipped in large lots Identical to valve process Production process Flow Controller 10 components More labour More production run More shipments

Competitive Position
Mature Market. Limited opportunities for innovation & declining profitability.

Wilkerson baffled by pricing situation.

One product line intense competition and discounting. However able to raise prices in other products.

Competitive Position
2 standard, high volume products (Valves & Pumps). Flow controllers Lower volume, higher customised & specialised. Increased indirect overhead costs (O/H rate is 300% DL).

What Should We Do?

Cost Analysis
Traditional Absorption Costing Cost Allocation (ABC) Product Profitability Analysis Operating Results ABC versus Absorption Costing Distribution of Overhead Costs

What Do We Expect To See?

Traditional Absorption Costing

Product 7,500 Units Valves ($) Direct Labour Direct Material Total Direct Costs 75,000 120,000 195,000 18% 29% 46% 12,500 Units Pumps ($) 156,250 250,000 406,250 18% 29% 46% 4,000 Units Flow Controllers ($) 40,000 88,000 128,000 16% 35% 52%

Manufacturing Overheads (300% of DL) Total Cost Allocation

225,000 420,000

54% 100%

468,750 875,000

54% 100%

120,000 248,000

48% 100%

Cost allocation (ABC)

Cost Pools

Cost Drivers

ActivityBased Rates

Cost allocation (ABC)

Direct Labour
Valves Pumps Flow Controllers $10 per unit $12.50 per unit $10 per unit

Direct Materials
Valves Pumps Flow Controllers $16 per unit $20 per unit $22 per unit

Manufacturing Overhead
Cost Pool (Exhibit 1) Machine Related Expenses Setup labour Receiving and production control Engineering Packaging and shipping Amount ($) Exhibit 1 336,000 40,000 180,000 100,000 150,000 Cost Driver Machine hours Production runs Production runs Hours of engineering work Number of shipments Amount (Exhibit 4) 11,200 machine hours 160 production runs 160 production runs 1,250 engineering hours 300 shipments Activity-Based Cost Rate $30 per machine hour $250 per production run $1,125 per production run $80 per engineering hour $500 per shipment

Cost allocation (ABC)

Product Valves ($) Direct Labour Direct Material Total Direct Costs Manufacturing Overheads - Machine Related Expenses - Setup labour - Receiving and production control - Engineering - Packaging and shipping Total Manufacturing Overheads Total Cost Allocation 112,500 2,500 11,250 20,000 5,000 151,250 346,250 32% 1% 3% 6% 1% 44% 100% 187,500 12,500 56,250 30,000 35,000 321,250 727,500 26% 2% 8% 4% 5% 44% 100% 36,000 25,000 112,500 50,000 110,000 333,500 461,500 8% 5% 24% 11% 24% 72% 100% 75,000 120,000 195,000 22% 35% 56% Pumps ($) 156,250 250,000 406,250 21% 34% 56% Flow Controllers ($) 40,000 88,000 128,000 9% 19% 28%

Product Profitability Analysis

TAC Valves Unit Produced Standard Unit Cost Planned Gross Margin Target Selling Price Actual Selling Price Actual Gross Margin 7500 $56.00 35% $86.15 $86.00 34.9% Pumps 12500 $70.00 35% $107.69 $87.00 19.5% Flow Controllers 4000 $62.00 35% $95.38 $105.00 41.0% Valves 7500 $46.17 35% $71.03 $86.00 46.3%

ABC Pumps 12500 $58.20 35% $89.54 $87.00 33.1% Flow Controllers 4000 $115.38 35% $177.50 $105.00 -9.9%

Operating Results

TAC ($) Sales Direct Labour Expense Direct Materials Expense Manufacturing Overhead Gross Margin General, Selling and Administration Expense Operating Income (pre-tax) 2,152,500 271,250 458,000 806,000 617,250 559,650 57,600 3% 29% 100% ($)

ABC

2,361,975 271,250 458,000 806,000 826,725 559,650 267,075

100%

35%

11%

Distribution of Overhead Costs

Valves ($) Direct Labour Direct Material Manufacturing Overheads - Machine Related Expenses - Setup labour - Receiving and production control - Engineering - Packaging and shipping Total Manufacturing Overheads Total Cost Allocation 112,500 2,500 11,250 20,000 5,000 151,250 346,250 33% 6% 6% 20% 3% 19% 23% 75,000 120,000 28% 26%

Pumps ($) 156,250 250,000 58% 55%

Flow Controllers ($) 40,000 88,000 15% 19%

Total ($) 271,251 458,001 100% 100%

187,500 12,500 56,250 30,000 35,000 321,250 727,500

56% 31% 31% 30% 23% 40% 47%

36,000 25,000 112,500 50,000 110,000 333,500 461,500

11% 62% 62% 50% 73% 41%

336,001 40,000 180,000 100,001 150,000 806,002

100% 100% 100% 100% 100% 100% 100%

30% 1,535,251

What Does This Mean?

Traditional costing and Activity Based Costing

Traditional Costing System - Advantages and disadvantages

Activity Based Costing System - Assessment of information usefulness and cost-benefit

Traditional costing System

Advantage Easy to understand and apply Less subjective Inaccurate cost structure (only volume related)

BUT

Advantage BUT

Cheaper Mislead managers in decision-making

Advantage BUT

Ideal for the mass-produced products

Not suitable for large companies

Activity Based Costing System

Advantage BUT Respond the limitations for absorption costing More fashionable than effective i.e. subjective and costly

Advantage

Ideal for the large companies, especially the services sector Cost drivers may not fully explain the cost behaviour

BUT

Implication of Wilkerson Case

Switching to ABC

Recommendations
Other strategic plans

Summarized solutions

Switching to ABCWhy?

The current cost system does not reflect market behaviour that fit with product profitability Wilkersons product lines are different in nature and delivery process
E.g. Pumps: High-volume Flow Controller: Customized

Overhead to total cost ratio (52.50%) is much greater than the DL to total cost ratio(17.67%)
Target pre-tax margin is achieved under ABC

Recommendation
Options

Retaining all production lines

Flow controllers

No change for Valves and Pumps

Close down

Continue operating

Enhance other lines New opportunities

Cost spread to other lines Less motivation of manager Risk of finding new opportunities

Quality control Reduce Cost

Demand decrease Time consuming Extra cost incurred

Company Target Overall performance and individual production line

Recommendation
Operational ABM
Product Attribute Change of Cost under ABC Suggestion Maintain the same price at $86 (34.9% - 46.3%; greater profit margin) Competitive status

Valves

High quality; Loyal customer base; Competitors do not intend to cut price

17.55% ($56-46.17)

Lower price High quality

Pumps

Major product line; Competitors reduced prices

16.86% ($70-58.2)

Maintain the same (recently lowered) price at $87 (19.5%-33.1%)

Average price Maintain sales volume

Flow Controllers

Generate 41% of total overhead; Customized; Underpriced

-Increase price to a range of $128 - $177 with target 86.10% margin of 10% - 35% ($62-115.38) -Cost reduction, quality control and better OH management (long-term)

Price at an acceptable gross margin

What Can Be Done

Operational Improvements
Perform batch and sustaining activities more efficiently e.g decrease setup times, lower cost of receiving and handling materials, lower cost of packaging & engineering support required for flow controllers. Product Design Improvements Redesign flow controllers less components, reduce demand for setup/engineering activities. Share components used in other products. Modify Customer Relationships: Be more aggressive on pricing for flow controllers. No reason to discount sales further if no complaints from customers.

Minimum Order size reduce o/h cost associated with small production runs/shipments.