Overview Case Study Information Costing Analysis Traditional costing and Activity based costing Implication of Wilkerson case Conclusion
Information • Business Structure of Wilkerson Company • Information about Prices and Costs • Current Issues from Operation
Business structure and Information Wilkerson Company
Valve
Pump
Flow controller
Actual Data Valves
Pumps
Flow Controller
Actual selling price
$86.00
$87.00
$105.00
Standard unit costs
$56.00
$70.00
$62.00
Actual gross margin (%)
34.9%
19.5%
41.0%
Valves
Pumps
Flow Controller
Target selling price
$86.15
$107.69
$95.38
Standard unit costs
$56.00
$70.00
$62.00
Target gross margin(%)
35.00%
35.00%
35.00%
Target
Business structure and Information Wilkerson Company
Valve
Pump
Flow controller
Standard unit costs Valves
Pumps
Flow Controller
Direct Labour cost
$10.00
$12.50
$10.00
Direct material cost
$16.00
$20.00
$22.00
Manufacturing overhead (@300%)
$30.00
$37.50
$30.00
Standard unit costs
$56.00
$70.00
$62.00
Valves
Pumps
Flow Controller
Production
• 4 component • 5 components • Produced and shipped in large lots • Identical to valve process
Production process
• 10 components • More labour • More production run • More shipments
Competitive Position • Mature Market. • Limited opportunities for innovation & declining profitability. • Wilkerson baffled by pricing situation. • One product line – intense competition and discounting. • However able to raise prices in other products.
Competitive Position • 2 standard, high volume products (Valves & Pumps). • Flow controllers – Lower volume, higher customised & specialised. • Increased indirect overhead costs (O/H rate is 300% DL).
What Should We Do?
Cost Analysis • Traditional Absorption Costing • Cost Allocation (ABC) • Product Profitability Analysis • Operating Results • ABC versus Absorption Costing • Distribution of Overhead Costs
What Do We Expect To See?
Traditional Absorption Costing
Product 7,500 Units
12,500 Units
4,000 Units
Valves ($)
Pumps ($)
Flow Controllers ($)
Direct Labour
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 (300% of DL)
225,000
54%
468,750
54%
120,000
48%
Total Cost Allocation
420,000
100%
875,000
100%
248,000
100%
Cost allocation (ABC)
Cost Pools
Cost Drivers
ActivityBased Rates
Cost allocation (ABC)
Direct Materials
Direct Labour Valves
$10 per unit
Valves
$16 per unit
Pumps
$12.50 per unit
Pumps
$20 per unit
Flow Controllers
$10 per unit
Flow Controllers
$22 per unit
Manufacturing Overhead Cost Pool (Exhibit 1)
Amount ($) Exhibit 1
Cost Driver
Amount (Exhibit 4)
Activity-Based Cost Rate
Machine Related Expenses
336,000
Machine hours
11,200 machine hours
$30 per machine hour
Setup labour
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
$500 per shipment
Cost allocation (ABC)
Product Valves ($)
Pumps ($)
Flow Controllers ($)
Direct Labour
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%
112,500
32%
187,500
26%
36,000
8%
- Setup labour
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%
Manufacturing Overheads - Machine Related Expenses
Product Profitability Analysis
TAC Valves Unit Produced
Pumps
ABC 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%
Target Selling Price
$86.15
$107.69
$95.38
$71.03
$89.54
$177.50
Actual Selling Price
$86.00
$87.00
$105.00
$86.00
$87.00
$105.00
Actual Gross Margin
34.9%
19.5%
41.0%
46.3%
33.1%
-9.9%
Standard Unit Cost Planned Gross Margin
Operating Results
TAC
ABC
($) Sales
2,152,500
($) 100%
2,361,975
Direct Labour Expense
271,250
271,250
Direct Materials Expense
458,000
458,000
Manufacturing Overhead
806,000
806,000
Gross Margin
617,250
General, Selling and Administration Expense
559,650
Operating Income (pre-tax)
57,600
29%
826,725
100%
35%
559,650 3%
267,075
11%
Distribution of Overhead Costs
Valves ($)
Pumps ($)
Flow Controllers ($)
Total ($)
Direct Labour
75,000
28%
156,250
58%
40,000
15%
271,251
100%
Direct Material
120,000
26%
250,000
55%
88,000
19%
458,001
100%
112,500
33%
187,500
56%
36,000
11%
336,001
100%
- Setup labour
2,500
6%
12,500
31%
25,000
62%
40,000
100%
- Receiving and production control
11,250
6%
56,250
31%
112,500
62%
180,000
100%
- Engineering
20,000
20%
30,000
30%
50,000
50%
100,001
100%
- Packaging and shipping
5,000
3%
35,000
23%
110,000
73%
150,000
100%
Total Manufacturing Overheads
151,250
19%
321,250
40%
333,500
41%
806,002
100%
Total Cost Allocation
346,250
23%
727,500
47%
461,500
30% 1,535,251
Manufacturing Overheads - Machine Related Expenses
100%
What Does This Mean?
Traditional costing and Activity Based Costing • Traditional Costing System - Advantages and disadvantages
• Activity Based Costing System - Assessment of information usefulness and cost-benefit
Traditional costing System Advantage
BUT
Advantage BUT
Advantage BUT
Easy to understand and apply Less subjective
• Inaccurate cost structure (only volume related)
Cheaper
• Mislead managers in decision-making
Ideal for the mass-produced products
• Not suitable for large companies
Activity Based Costing System Advantage BUT
Advantage
BUT
Respond the limitations for absorption costing
• More fashionable than effective i.e. subjective and costly
Ideal for the large companies, especially the services sector
• Cost drivers may not fully explain the cost behaviour
Implication of Wilkerson Case
Switching to ABC
Recommendations
Other strategic plans
Summarized solutions
Switching to ABC…Why?
The current cost system does not reflect market behaviour that fit with product profitability Wilkerson’s product lines are different in nature and
delivery process
E.g. Pumps: High-volume Flow Controller: Customized
Overhead to total cost ratio (52.50%) is much greater than the DL to total cost ratio(17.67%) Target pre-tax margin is achieved under ABC
Recommendation Options
No change for Valves and Pumps
Retaining all production lines Flow controllers
Close down
Enhance other lines New opportunities Cost spread to other lines Less motivation of manager Risk of finding new opportunities
Continue operating
Quality control Reduce Cost Demand decrease Time consuming Extra cost incurred
Company Target Overall performance and individual production line
Recommendation Operational ABM Product
Attribute
Valves
High quality; Loyal customer base; Competitors do not intend to cut price
Major product line; Pumps
Competitors’ reduced
prices
Flow Controllers
Generate 41% of total overhead; Customized; Underpriced
Change of Cost under ABC
17.55% ($56-46.17)
16.86% ($70-58.2)
Suggestion
Competitive status
Maintain the same price at $86 (34.9% - 46.3%; greater profit margin)
Lower price High quality
Maintain the same (recently lowered) price at $87 (19.5%-33.1%)
Average price Maintain sales volume
-Increase price to a range of $128 - $177 with target 86.10% margin of 10% - 35% ($62-115.38) -Cost reduction, quality control and better OH
Price at an acceptable gross margin
What Can Be Done Operational Improvements •Perform batch and sustaining activities more efficiently – e.g decrease setup
times, lower cost of receiving and handling materials, lower cost of packaging & engineering support required for flow controllers. •Product Design Improvements •Redesign flow controllers – less components, reduce demand for set-
up/engineering activities. Share components used in other products. •Modify Customer Relationships: •Be more aggressive on pricing for flow controllers. •No reason to discount sales further if no complaints from customers. •Minimum Order size – reduce o/h cost associated with small production
runs/shipments.
