Wilkerson – A Case Study about Activity Based Costing

Wilkerson – A Case Study about Activity Based Costing
Wilkerson Company
The decline in our profits has become intolerable. The severe price cutting in pumps has
dropped our pre-tax margin to less than 3%, far below our historical 10% margins. Fortunately,
our competitors are overlooking the opportunities for profit in flow controllers. Our recent
10% price increase in that line has been implemented without losing any business.
Robert Parker, president of the Wilkerson Company, was discussing operating results in the latest
month with Peggy Knight, his controller, and John Scott, his manufacturing manager. The meeting
among the three was taking place in an atmosphere tinged with apprehension because competitors
had been reducing prices on pumps, Wilkerson’s major product line. Since pumps were a
commodity product, Parker had seen no alternative but to match the reduced prices to maintain
volume. But the price cuts had led to declining company profits, especially in the pump line
(summary operating results for the previous month, March 2000, are shown in
Exhibits 1 and 2
).
Wilkerson supplied products to manufacturers of water purification equipment. The company
had started with a unique design for valves that it could produce to tolerances that were better than
any in the industry. Parker quickly established a loyal customer base because of the high quality of its
manufactured valves. He and Scott realized that Wilkerson’s existing labor skills and machining
equipment could also be used to produce pumps and flow controllers, products that were also
purchased by its customers. They soon established a major presence in the high-volume pump
product line and the more customized flow controller line.
Wilkerson’s production process started with the purchase of semi-finished components from
several suppliers. It machined these parts to the required tolerances and assembled them in the
company’s modern manufacturing facility. The same equipment and labor were used for all three
product lines, and production runs were scheduled to match customer shipping requirements.
Suppliers and customers had agreed to just-in-time deliveries, and products were packed and
shipped as completed.
Valves were produced by assembling four different machined components. Scott had designed
machines that held components in fixtures so that they could be machined automatically. The valves
were standard products and could be produced and shipped in large lots. Although Scott felt several
competitors could now match Parker’s quality in valves, none had tried to gain market share by
cutting price, and gross margins had been maintained at a standard 35%.
101-092
Wilkerson Company
2
The manufacturing process for pumps was practically identical to that for valves. Five
components were machined and then assembled into the final product. The pumps were shipped to
industrial product distributors after assembly. Recently, it seemed as if each month brought new
reports of reduced prices for pumps. Wilkerson had matched the lower prices so that it would not
give up its place as a major pump supplier. Gross margins on pump sales in the latest month had
fallen below 20%, well below the company’s planned gross margin of 35%.
Flow controllers were devices that controlled the rate and direction of flow of chemicals. They
required more components and more labor, than pumps or valves, for each finished unit. Also, there
was much more variety in the types of flow controllers used in industry, so many more production
runs and shipments were performed for this product line than for valves. Wilkerson had recently
raised flow controller prices by more than 10% with no apparent effect on demand.
Wilkerson had always used a simple cost accounting system. Each unit of product was charged
for direct material and labor cost. Material cost was based on the prices paid for components under
annual purchasing agreements. Labor rates, including fringe benefits, were $25 per hour, and were
charged to products based on the standard run times for each product (see
Exhibit 3
). The company
had only one producing department, in which components were both machined and assembled into
finished products. The overhead costs in this department were allocated to products as a percentage
of production-run direct labor cost. Currently, the rate was 300%. Since direct labor cost had to be
recorded anyway to prepare factory payroll, this was an inexpensive way to allocate overhead costs
to products.
Knight noted that some companies didn’t allocate any overhead costs to products, treating them
as period, not product, expenses. For these companies, product profitability was measured at the
contribution margin level
!
price less all variable costs. Wilkerson’s variable costs were only its direct
material and direct labor costs. On that basis, all products, including pumps, would be generating
substantial contribution to overhead and profits. She thought that perhaps some of Wilkerson’s
competitors were following this procedure and pricing to cover variable costs.
Knight had recently led a small task force to study Wilkerson’s overhead costs since they had now
become much larger than the direct labor expenses. The study had revealed the following
information:
1.
Workers often operated several of the machines simultaneously once they were set up. For
other operations, however, workers could operate only one machine. Thus machine-related
expenses might relate more to the machine hours of a product than to its production-run labor
hours.
2.
A set-up had to be performed each time a batch of components had to be machined in a
production run. Each component in a product required a separate production run to machine
the raw materials or purchased part to the specifications for the product.
3.
People in the receiving and production control departments ordered, processed, inspected,
and moved each batch of components for a production run. This work required about the
same amount of time whether the components were for a long or a short production run, or
whether the components were expensive or inexpensive.
4.
The work in the packaging and shipping area had increased during the past couple of years as
Wilkerson increased the number of customers it served. Each time products were packaged
and shipped, about the same amount of work was required, regardless of the number of items
in the shipment.

 

Requirements:
Your team has been invited by the management of Wilkerson Company (WC) to present an overview of the issues facing the company. You are required to write a report to the management of WC, addressing the issues shown below. The report should be no more than 5 pages (excluding the title page, reference list, and appendices).
A. Write an executive summary to highlight the competitive situation that the management is currently facing.
B. The management of WC are investigating the existing costing systems:
1. How does WC’s existing costing system operate? Your answer should include a diagram that shows how costs flow from factory expense accounts to products, AND brief comments on the strength and weaknesses of the current costing system.
2. What are the differences between WC’s existing costing system and a traditional costing system used by service organizations such as hospitals and banks? Your answer should include discussions of (i) cost structure, (ii) cost drivers, (3) inventory, product, and customer costs.
3. What will be the consequences on the competitive situation of the company if the management decide to switch from the existing costing system to:
I. a contribution margin approach,
II. a traditional costing system that uses machine hours to allocate the overhead costs. (6 marks)

(You should show calculations to support your argument)
C. The management of WC notes that cost accuracy is crucial for product pricing and customer retainment. You have been asked to address the following issues in your report:
1. Use the information in the case, including Exhibits 1, 2, 3 and 4 to propose a more relevant costing system for WC. Your answer should include a diagram that shows how costs flow from factory expense accounts to products. Then use the costing system you have proposed to allocate WC’s overhead costs AND provide your best estimates about the cost and profitability of WC’s three product lines.
2. Compare the costs and profit per product you have calculated using your recommended costing system in (C.1) and the estimated costs using WC’s current costing system:
a. What causes the two costing systems to provide different cost estimates?
b. Which costing system provides the management of WC with better information? Why?
c. Specify three concerns regarding the costing system you have proposed in C.1 above.
D. Drawing in your answers on (C) above:
1. What are the strategic implications of your analysis?
2. Specify three actions that the management of WC should consider in order to improve the company’s profitability?
3. WC have been compensating their salespersons with commissions on their gross sales volumes (less return). Advise the management of WC on whether they should change this incentive system? Why/Why not?
PLACE THIS ORDER OR A SIMILAR ORDER WITH US TODAY AND GET AN AMAZING DISCOUNT 🙂