Wilkerson Case Study 1. The competitive situation is different between the products. Pumps are commodity products, produced in high volumes for a market with high price competition - price cutting by competitors led to a drop of Wilkerson’s pre-tax pre-tax margin to under 3%, gross margin on sales for pump sales has fallen below 20%. Flow controllers are customized products, sold in a less competitive market with inelastic demand at the current price range. Valves are standard, produced and shipped in large l ots - gross margins have been maintained at 35%. Wilkerson is a quality leader, but this leadership may soon be contested by several competitors. Although they are able to match Wilkerson's quality, there are no signs of price competition yet. Nevertheless, in the long-run Wilkerson should be prepared to compete on price. The price price competition competition pushes Wilkerson Wilkerson to analyze analyze its overhead costs, costs, since no reserves reserves of cost cutting are left in its supply chain (both customer and suppliers agreed to just-in-time delivery). 2. The problem in the current pricing method used by Wilkerson is that the real manufacturing cost of each product is not realistic because of the high proportion of overhead costs which are 806,000 of 1,535,250 (52.5%) The current method assumes the overhead costs are correlated to the labor costs at 300% rate, while many of the overhead activities are performed per product line regardless of the amount of units produced. The approach of treating the overhead expenses as a period expense, suggests that the product cost and profitability will be measured without overhead costs (by increasing the profitability margins). This means there is a correlation between the variable costs (labors and materials) to the product price. The method doesn't consider the different activities performed for each product line. Although in a lucky way better reflects the real cost of the products, giving more weight of the overhead costs to the Flow Controllers, just because their material price is higher, but not
from the real reason (higher activity costs), this solution is not good from similar reasons like the current method.
3. Wilkerson's existing cost system system of is the traditional volume-based costing: Direct materials and labor costs are based on standard prices of materials and labor rates. In addition, the manufacturing manufacturing overhead is also considered as cost and it is allocated in proportion to t o direct labor cost at the rate of 300% (Based on the assumption that there’s a direct relationship between volume volume of production of of individual products and level of overhead). overhead).
Product
Valves
Pumps
Flow Controllers
Total
# of Units
7500
12500
4000
24000
Direct Labor
75000
156250
40000
271250
Direct Material
120000
250000
88000
458000
Total Direct Costs
195000
406250
128000
729250
Overhead Costs (300% of DL) Total Cost Allocation
225000
468750
120000
813750 (806000)
420000
875000
248000
1543000
4. As overhead costs are not in proportion with the volume of production output the cost system Wilkerson is using at the moment is an inappropriate method that leads to wrong assumptions when analyzing profitability and therefore leads to wrong pricing decisions and ineffective cost management. management. Activity based costing helps to find the real relationship between the volume of production of a product and the overhead. In a first step it is necessary necessary to define cost pools and find the drivers of those costs. In Wilkerson’s Wilkerson’s case the different pools would be machine related expenses, set up labor, receiving and production control, packaging and shipping and engineering. The related cost drivers are machine hours, production runs, hours of engineering work and number of shipments.
Table 1 - Cost Pools Pools -> Cost Cost Drivers -> Activity-Based Activity-Based Cost Rate Rate
Amount Cost Pool
($)
Cost Driver
Amount
Machine Related Expenses
336,000
Machine hours
11,200 machine hours $30 per machine hour
Setup labour
40,000
Production runs
160 production runs
180,000
Production runs
160 production runs
Hours of engineering
1,250 engineering
$80 per engineering
work
hours
hour
Number of shipments
300 shipments
$500 per shipment
Receiving and production control Engineering
100,000
Packaging and shipping
150,000
Activity-Based Cost Rate
$250 per production run $1,125 per production run
Table 2 - Activity-Based Cost Calculation per product (using data from Exhibit 4)
Product Units 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
Valves
Pumps
Flow Controllers 4000 40,000 88,000 128,000
7500 75,000 120,000 195,000
12500 156,250 250,000 406,250
112,500
187,500
36,000
2,500
12,500
25,000
11,250
56,250
112,500
20,000
30,000
50,000
5,000
35,000
110,000
151,250
321,250
333,500
346,250
727,500
461,500
From table 3 we can see that t hat flow controllers are not contributing in a positive way as they have a negative gross margin of -9.90%. While Valves have a higher margin (46.3%) and also Pumps have a higher gross margin with 33.1%. Vales and Pumps are therefore actually much more attractive for the company than they had expected while Flow controllers contributes a negative gross margin.
Table 3 – Comparing between costing methods
Method Product Unit Produced Standard Unit Cost Planned Gross Margin Target Selling Price Actual Selling Price Actual Gross Margin
Existing Cost System Valves
Pumps
Activity-Based Cost System Flow Controllers
Valves
Pumps
Flow Controllers
7500
12500
4000
7500
12500
4000
$56.00
$70.00
$62.00
$46.17
$58.20
$115.38
35%
35%
35%
35%
35%
35%
$86.15
$107.69
$95.38
$71.03
$89.54
$177.50
$86.00
$87.00
$105.00
$86.00
$87.00
$105.00
34.9%
19.5%
41.0%
46.3%
33.1%
-9.9%
Using cost drivers for the calculation gives much more accurate information about the actual production costs. costs. When looking at the gross margins margins in Exhibit 2 in the case Valves Valves had a margin of 34.9%, Pumps a margin of 19.5% and Flow controllers of 41%. Therefore you can deduct that Pumps and Valves are more attractive for the company than they actually thought. The shifts in costs and profitability are caused of the change of cost method, to a method which is more accurate.
5. The first thing to take care of is the Flow Controllers, as the Wilkerson's management management team can take advantage of the favorable competitive situation in this market which is the inelastic demand and the lack of competition, and therefore raise their price up to the range between 116-177.5, depends on the market reaction (even if the previous 10% price raise didn't damaged the sales, a 50% raise may damage them). Also the management team can compete in the price competition on the valves and pumps to maintain and maybe increase their market share , although an exam should be made in order to check if the price decrease decrease will harm the profit. 6. The cost calculations in question 4 are sensitive to the utilization of the product line. We based our numbers numbers on the information information of March 2000, 2000, which is mentioned mentioned as a typical typical month, but it is also mentioned mentioned that on months months of high demand demand machines worked 12,000 hours, hours, factory handled 180 production runs and 400 shipments The cost calculations would be best achieved if we based it on past years demands charts which include seasonal shifts in demands. The cost of the resources and labor can also change during time and should be updated for accurate cost calculation. 7. The current salespersons incentive system, based on volumes only, drives the salespersons to maximize maximize their sales regardless Wilkerson's Wilkerson's profit. There are 2 main problems1. The salespersons will want to sell for the lowest price they can, in order to increase i ncrease their sales volume. 2. If the Company has several product lines, the salespersons do not necessarily have the incentive to sell the most profitable products, but only the products generating maximal volumes. I recommend recommend on changing the incentive system to compensation on the profit generated from each sale, based on the known values of cost of each product using Activity-Based Costs. In this way the interests are similar and t he salespersons will gain more when the company will profit more.
