Wilkerson Case

The purpose of this report is discussing the case of Wilkerson Company that confronting tough competition in price cutting in pumps which caused to a big drop of pre-tax operating income from 10% to 3%. After observing the existing costing allocation, we found out there is an issue on the existing costing report that the manager could not be able to see the real situation. In light of this, there will be brought to the discussion on the feasibility of using an alternative costing method - Activity based costing (ABC) in the latter paragraphs.

The issue of misallocation cost

With the use of Traditional Absorption Costing (TAC) which means Wilkerson Company is now only put the costing of direct labor and material in place. As we can see the table 1 below, the percentage of total direct cost allocation in Valves, Pumps and Flow Controllers are 46%, 46% and 52% respectively, and so for the manufacturing overhead are 54%, 54% and 48%.

Table 1: Traditional Absorption Costing

Product

Valves ($) Pumps ($) Flow Controllers ($)

Direct Labor 75,000 18% 156,250 18% 40,000 16%

Direct Material 120,000 29% 250,000 29% 88,000 35%

Total Direct Costs 195,000 46% 406,250 46% 128,000 52%

Manufacturing Overheads 225,000 54% 468,750 54% 120,000 48%

Total Cost Allocation 420,000 100% 875,000 100% 248,000 100%

Now if we go for ABC method, the company then requires the following six basic steps according to Ray H. Garrison and Eric W. Noreen to implement an ABC system as below:

1. Identify and define cost pools and cost drivers

2. Directly trace costs to activities (to the extent feasible)

3. Assign costs to activity cost pools

4. Calculate activity rates

5. Assign costs to cost objects using the activity rates and activity measures previously determined

6. Prepare and distribute management reports

With refer to the monthly production and operating statistics in March 2000, we can identify the cost pools and cost drivers which are machine related expenses with machine hours, setup labor with production runs, receiving and production control with production runs, engineering with the hours of engineering work and packaging as well as shipping with numbers of shipments. Then, the activity-based cost rate can be easily generated from plotting the figures from the section of manufacturing overhead below. Now, we can clearly know the rate of each manufacturing activities, for example, the cost rate of machine hour can be calculated from the amount of cost pool divided by the amount of cost driver which is $33,600/112,00 hours =$30 per machine hour for the cost of activity.

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Table 2: Manufacturing Overhead

Cost Pool Amount ($) Cost Driver Amount Activity-Based Cost Rate

Machine Related Expenses 336,000 Machine hours 11,200 machine hours $30 per machine hour

Setup labor 40,000 Production runs 160 production runs $250 per production run

Receiving and production control 180,000 Production runs 160 production runs $1,125 per production run

Engineering 100,000 Hours of engineering work 1,250 engineering hours $80 per engineering hour

Packaging and shipping 150,000 Number of shipments 300 shipments $500 per shipment

Once we have all the costing information as above, we can generate a comprehensive costing report. As we seen from the table 2 below under ABC system, now the total direct costs for Valves, Pumps and Flow Controllers have been changed accordingly which are 56%, 56% and 28% respectively since the number has been calculated in using the actual used of resources rather than supplied. In addition, the figures of manufacturing overheads have also been changed based on the calculation of each manufacturing process in terms of the actual numbers of activities have been taken place for each product lines. With the figures we have from TAC originally and we now generated the figures under ABC system, we can obviously make the comparison between these two methods in the following paragraph.

Table 3: Cost Allocation (ABC)

Product

Valves ($) Pumps ($) Flow Controllers ($)

Direct Labor 75,000 22% 156,250 21% 40,000 9%

Direct Material 120,000 35% 250,000 34% 88,000 19%

Total Direct Costs 195,000 56% 406,250 56% 128,000 28%

Manufacturing Overheads

- Machine Related Expenses 112,500 32% 187,500 26% 36,000 8%

- Setup labor 2,500 1% 12,500 2% 25,000 5%

- Receiving and production control 11,250 3% 56,250 8% 112,500 24%

- Engineering 20,000 6% 30,000 4% 50,000 11%

- Packaging and shipping 5,000 1% 35,000 5% 110,000 24%

Total Manufacturing Overheads 151,250 44% 321,250 44% 333,500 72%

Total Cost Allocation 346,250 100% 727,500 100% 461,500 100%

In comparing the product profitability analysis between the use of TAC and ABC, the table 3 below clearly shown that actual gross margin have been changed because of using different costing approach in ABC which reflects the real unit cost for Valves, Pumps and Flow Controllers. In using the ABC system, Valves and Pumps are matching the company's target of 35% of gross margin apart from Flow Controllers. With the use of TAC, the gross margin on pump sales is 19.5% that well below the company's target gross margin of 35%. This indicates that the current overhead cost allocation practice did not reflect the real costs incurred on the products. The lower actual gross profit obtained was mainly due to wrong cost allocation on the pump product.

Table 4: Product Profitability Analysis

TAC ABC