Question

Wilkerson case

You may presume the following:

Capacity for the plant is 180 production runs, 400 shipments, 12,000 machine hours. Actual and capacity engineering hours are the same at 1,250.

The number of batches is equal to the number of production runs.

Answer these questions (in this order):

1. What is the competitive situation faced by Wilkerson?

2. Given some of the apparent problems with Wilkerson’s cost 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?

3. How does Wilkerson’s existing cost system operate? Develop a diagram to show how costs flow from factory expense accounts to products. In other words, how do machine expense, set-up labor, receiving/production control, engineering, and packaging/shipping costs get allocated to valves, pumps, and flow controllers?

Answer 1

1. What is the competitive situation faced by Wilkerson?

The competition varies for Wilkerson's products. Pump see very severe price competition as they are commodity products and are produced in high volumes. Whereas Flow controllers can be customized and do not face a lot of competition in the market as the demand does not change with the current price range. Another product, Valves are produced in large numbers. Wilkerson produces quality products but struggles to understand the price competition out there in the market. Right now, Wilkerson has not been contested by competitors on Valve pricing but they must be prepared to compete on price. Price competition will push Wilkerson to analyze and evaluate its overhead costs as it might make the production process approach unrealistic.

Competitive Situation faced (Product Wise) -

1. Pumps - Competitive Pricing, Decrease in profit due to price cutting, Costly to produce but lower margins, Current Margin is at 3%, Sales are falling below 20%

2. Valves - Less Competiton, Startardised Product, Machine automated leading major presence

3. Flow Controllers - Most resource-intensive,  No attempt by competitors, Increase in price does not lead to lose in demand. Margins maintained at 41%

2. Given some of the apparent problems with Wilkerson’s cost system, should executives abandon overhead assignments to products entirely by adopting a contribution margin approach in which manufacturing overhead is treated as a period expense? Why or why not?

Wilkerson follows Volume-based costing which means the allocation of overhead costs is based on a unit of activity rather than a cost. Example - Costs are based on the number of labor hours, Machine hours, number of units produced. Overhead costs are estimated by multiplying direct labor costs by 300%. This may lead to an inadequate estimated of the unit cost.

Below are the two factors that show volume-based costing may result in inadequate estimates.

1. Overhead costs are estimated quite high (300% to direct labor cost)

2. Expect higher unit costs for flow controllers are they are customized, whereas Pumps and Valves are standard products, unit costs will be lower as compared.

Advantages of adopting a Contribution Margin Approach:

1. It separates the fixed and variable costs.

2. Help understand the variable costs attached to all three products. This further helps the company to be aware of which costs are increasing when the production is increasing. In a traditional approach, it is difficult to understand which costs are increasing during production.

Though this approach is really helpful with short term decision making but might be unreliable when overhead costs are so significant.

Option 2: Activity-based Costing

1. Activity-based costing helps identifies activities in an organization and assigns cost to each activity. It also helps finds an individual relationship between the volume of production and different overheads.

2. Wilkerson can divide different overhead costs into different groups and choose the most appropriate cost drivers which are directly related to the volume of production.

3. ABC provides accurate information about product cost and, therefore, their gross margins.

3. How does Wilkerson’s existing cost system operate? Develop a diagram to show how costs flow from factory expense accounts to products. In other words, how do machine expense, set-up labor, receiving/production control, engineering, and packaging/shipping costs get allocated to valves, pumps, and flow controllers?

Please refer to the image below:

Wilkerson can divide different overhead costs into different groups and choose the most appropriate cost drivers which are directly related to the volume of production.

Example of the Cost Pool -

1.Machine Related Expenses - Machine Hours

2. Setup labor - Production Runs

3. Receiving and Production Control - Production Runs

4. Engineering - Hours of Engineering Work

5. Packaging & Shipment - Number of Shipments

Determine the Cost Driver rate - Each cost driver rate is multiplied by the volume of cost driver for an individual product and then divided by the volume of production of this product.