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Wilkerson Company

Introduction

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.

Analysis

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
■ Engineering
■ 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

Margin Calculation Valves Pumps Flow Controllers
Planned Selling Price 86.15 107.69 95.38
Actual Selling Price 86 87 105
Per unit Volume Based Costing (Exhibit
2) 56 70 62
Margin (based on Planned SP) 35.00% 35.00% 35.00%
Margin (based on Actual SP) 34.88% 19.54% 40.95%

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%).

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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.

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

Receiving and
Machine Related Setup Labour Engineering Packaging and
Cost Drivers and Rates production control
Expenses Costs costs Shipping Costs
costs
Manufacturing
Overheads (Exhibit 1) 3,36,000 40,000 1,80,000 1,00,000 1,50,000
Number of
Machine hrs Production Production Run
Cost drivers Eng Hrs shipments
(Point 1) Run (Point 2) (Point 3)
(Point 4)
Value(Exhibit 4) 11,200 160 160 1,250 300
   
Rate 30 250 1,125 80 500

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
Product wise Costing Valves Pumps Flow Controllers Total

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Machine Hrs 3,750 6,250 1,200  

Machine Related Expenses 1,12,500 1,87,500 36,000 3,36,000
   
Production Runs 10 50 100  
Setup Labor Expenses 2,500 12,500 25,000 40,000
Receiving and production costs 11,250 56,250 1,12,500 1,80,000
   
Engineering Hrs 250 375 625  
Engineering Expenses 20,000 30,000 50,000 1,00,000
   
No of shipments 10 70 220  
Packaging & Shipping Costs 5,000 35,000 1,10,000 1,50,000
   
Total Overhead Expenses       8,06,000

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

Per unit Activity Based Costing Valves Pumps Flow Controllers
Production Units 7,500.0 12,500.0 4,000.0
Direct Labor Cost 10.0 12.5 10.0
Direct Material Cost 16.0 20.0 22.0
   
Machine Related Expenses 15.0 15.0 9.0
Setup Labor Expenses 0.33 1.00 6.25
Receiving and production 1.5 4.5 28.1
Engineering Expenses 2.67 2.40 12.50
Shipping Expenses 0.67 2.80 27.50
Total 46.17 58.20 115.38

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

Margin Calculation Valves Pumps Flow Controllers

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Planned Selling Price 86.15 107.69 95.38
Actual Selling Price 86 87 105
Per unit Activity Based Costing (calc in
Table 3) 46.17 58.20 115.38
Margin (based on Planned SP) 46.41% 45.96% -20.96%
Margin (based on Actual SP) 46.32% 33.10% -9.88%

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.

Recommendations

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

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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.

MA Final
Assignment.xlsx
Embedded Excel Sheet:

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