Variable Cost

Wilkerson Company Case

1. What is the competitive situation faced by Wilkerson? The competitive situation faced by Wilkerson is quite severe. Price cutting in its main product has led to a huge drop in profit. While price increase in another product line partially made up the loss. We will discuss the detailed situation line by line. (1) Valves It was the first product line developed by Wilkerson and its high quality brought it a loyal customer base.

Even if several competitors could match Wilkerson’s quality in valves, none had tried to gain market share by cutting price. Therefore the competitive situation for valves was not so fierce that Wilkerson could maintain its gross margin. (2) Pumps Pump product line’s characteristic is high-volume and the manufacturing process for pumps was practically identical to that for valves. Due to the severe competitive situation for pumps, its market price has reduced continuously, so that Wilkerson had to match the low price to maintain its market share and sales volume. (3) Flow controllers The biggest characteristic of flow controllers is customized, so that they required more components and more labor than the other two products, as well as more production runs and shipments. Due to variety of product and competitors’ overlooking, the price rise did not have apparent effect on demand.

2. Given some of the apparent problems with Wilkerson’s cot system, should executives abandon overhead assignment to products entirely by adopting a contribution margin approach in which manufacturing overhead is treated as a period expense?

Why or why not? Given Wilkerson’s current situation, we consider that executives should not abandon overhead assignment to products entirely by adopting a contribution margin approach. Two conspicuous reasons are listed below. First of all, the biggest problem faced by Wilkerson’s executives was to figure out the profitability of each product line. Therefore, they must try to allocate overhead to each product line as detailed as possible, which means that treating the entire overhead as a period expense was not a sagacious decision.

Moreover, the main advantage of variable costing system is to prevent executives from overproducing, which is not applicable for Wilkerson because of its just-in-time producing system. All in all, it is not a good choice for Wilkerson to abandon overhead assignment to products entirely by adopting a contribution margin approach in which manufacturing overhead is treated as a period expense.

3. How does Wilkerson’s existing cost system operate? Develop a diagram to show how costs flow from factory expense accounts to products. Engineering $100,000 Engineering 100,000 Packaging and shipping $150,000 Packaging and shipping $150,000 Setup labor $40,000 Setup labor $40,000 Machine-related Expense $336,000 Machine-related Expense $336,000 Wilkerson’s existing cost system operates as the following diagram. Receiving and production control $180,000 Receiving and production control $180,000 Production Cost Centre $806,000 Production Cost Centre $806,000 300% x Direct Labour Cost 300% x Direct Labour Cost Direct material Direct labour Direct material Direct labour Valves, Pumps, Flow Controllers Valves, Pumps, Flow Controllers . Develop and diagram an activity-based cost model using the information in the case. Provide your best estimates about the cost and profitability of Wilkerson’s three product lines. What difference does your cost assignment have on reported product costs and profitability? What causes any shifts in cost and profitability? (1) Activity-based cost model operates as the following diagram. Manufacturing overhead $806,000 Manufacturing overhead $806,000 Machine-related activities $336,000 Machine-related activities $336,000 Setting up machines $40,000

Setting up machines $40,000 Receiving and controlling $180,000 Receiving and controlling $180,000 Providing engineering $100,000 Providing engineering $100,000 Packaging and shipping $150,000 Packaging and shipping $150,000 # of shipments # of shipments Engineering hours Engineering hours Machine hours Machine hours # of production runs # of production runs # of production runs # of production runs Direct material Direct labour Direct material Direct labour Valves, Pumps, Flow Controllers Valves, Pumps, Flow Controllers (2) Activity-based cost driver rates

Activity| cost| Cost driver| # of cost driver| Cost driver rate| Machine-related activities| 336,000| Machine hours| 11,200| 30| Setting up machines| 40,000| # of production runs| 160| 250| Receiving and controlling| 180,000| # of production runs| 160| 1,125| Providing engineering| 100,000| Engineering hours| 1,250| 80| Packaging and shipping| 150,000| # of shipments| 300| 500| Summary of product lines’ overhead cost allocation | Valves | Pumps | Flow controllers| ABC overhead cost per unit| | | | Machine-related activities| 15. 00| 15. 00| 9. 0| Setting up machines| 0. 33| 1. 00| 6. 25| Receiving and controlling| 1. 50| 4. 50| 28. 13| Providing engineering| 2. 67| 2. 40| 12. 50| Packaging and shipping| 0. 67| 2. 80| 27. 50| Total| 20. 17| 25. 70| 83. 38| Summary of product lines’ cost and profitability in activity-based costing | Valves| Pumps| Flow controllers| Direct labor| 10. 00| 12. 50| 10. 00| Direct materials | 16. 00| 20. 00| 22. 00| Overheads| 20. 17| 25. 70| 83. 83| Total cost | 46. 17| 58. 20| 115. 38| Selling price| 86. 00| 87. 00| 105. 00| Gross margin| 46. 31%| 33. 0%| -9. 89%| (3) Summary of the differences between ABC cost assignment and existing system | Valves| Pumps| Flow controllers| | Existing | ABC| Existing | ABC| Existing | ABC| Direct labor| 10. 00| 10. 00| 12. 50| 12. 50| 10. 00| 10. 00| Direct materials | 16. 00| 16. 00| 20. 00| 20. 00| 22. 00| 22. 00| Overheads| 30. 00| 20. 17| 37. 50| 25. 70| 30. 00| 83. 83| Total cost | 56. 00| 46. 17| 70. 00| 58. 20| 62. 00| 115. 38| Selling price| 86. 00| 86. 00| 87. 00| 87. 00| 105. 00| 105. 00| Gross margin| 34. 90%| 46. 31%| 19. 50%| 33. 10%| 41. 0%| -9. 89%| From the table above, we can get the following conclusion. Valves are more profitable than executives thought. Even if Wilkerson cut the price of pumps, it still achieved the target margin. Flow Controllers have a negative gross margin; therefore the increasing price did not decrease the demand. (4) Cost drivers of three product lines Cost driver | Valves| Pumps| Flow controllers| Units per machine hour | 2| 2| 3. 33| Units per production run| 750| 250| 40| Units per shipment| 750| 179| 18| Units per engineering hour | 30| 33. 33| 6. 4|

As we have mentioned above, the biggest characteristic of flow controllers is customized, so that they require more components and more labor than the other two products, as well as more production runs and shipments. This can be obviously recognized from the table, that flow controllers are produced and shipped in smaller batches and require more engineering hours. Therefore, the existing system which allocates overhead according to the direct labor is not accurate enough, and causes the differences.

5. Based on your analysis for Question 4, what actions might Wilkerson’s management team consider to improve the company’s profitability?

Based on our analysis for Question 4, several actions could be taken to improve Wilkerson’s profitability. (1) Since flow controllers’ cost were much high than management expected, Wilkerson could redesign its producing process to lower the amount of activities. At the same time, company should try to perform activities at a lower cost. (2) Using ABC analysis, we found that Wilkerson’s pricing strategy was not proper enough to achieve its gross margin target. For example, management could increase the price of flow controllers, meet the market price for pumps, and watch competitors’ price of valves as well. (3) Especially for flow controllers, management could change customer order patterns, that is to say increasing the amount of products per shipment in order to decrease the cost of shipments.

6. What concerns, if any, do you have with the cost estimates you prepare in the answer to Question 4? What other information or analysis would you want for better cost and profitability estimates? The cost drivers of activity-based cost method are much more than those of absorption cost method so that it causes much higher developing and maintenance expenses.

Although we have computer and database technologies nowadays, the cost of using the time-consuming activity-based cost method is still high. It is worthy of using the activity-based cost method instead of the previous one for the management team in order to make a wise manufacturing decision. Furthermore, the financial report with the activity-based cost method leaves much work to do to meet the requirements of the financial report for outsiders. It often takes the accounting department plenty of time to make an appropriate adjustment of the report. Therefore the labor cost would be increased as the workload is heavier.

Moreover, it is quite hard for us to figure out the true cost drivers since not all indirect cost has a close relation with the cost drivers, for instance, almost all the assuming cost drivers have a low relation with the cost sometimes. If the cost driver is not right, the production cost would be distortion a lot as a result. It does not reveal the process of identifying the cost drivers so that the result is probably unbelievable. The absorption cost method enables the company to build up cost center for cost controlling and performance evaluation of each department.

However, the cost pool of the activity-based cost method does not go along with the organization of the company. Thus it fails to provide the management team enough management and production control information. Some people in the management team oppose this method so much because it weakens the usefulness of the accounting data for the management control. I want more information on the detailed production process of each product such as the activities it involves and data for identifying cost drivers for better cost and profitability estimates.

7. Wilkerson has been compensating salespersons with commissions on their gross sales volumes(less returns). Parker wonders whether the company should change this incentive system. It is not a good incentive system for the company and Wilkerson should change it. Under this incentive system, every sales person would try his best to sell out much more product regardless the profitability of the company as a whole. They should design a new incentive system to make every sales person to sell more products with high margins. Furthermore, different products should have different incentive policies due to their different margins and characteristics.