Question

Wilkerson Case

Prepare a table ( per unit and in total) showing sales, direct labor expenses, material expenses, machine expenses overhead, setup labor overhead, receiving/ production control overhead, engineering overhead, packaging/ ship overhead, margin, and margin % for valves, pumps, flow controllers, unused capacity (difference between capacity units and actual driver unit usage x driver rate figured at capacity levels), and in total using driver rates based on capacity usage levels (machine hours, production runs, engineering hours and shipments.)

Wilkerson Company

The decline in our profits has become intolerable. The severe price cutting in pumps has dropped our pre-tax margin to less than 3%, far below our historical 10% margins. Fortunately, our competitors are overlooking the opportunities for profit in flow controllers. Our recent 10% price increase in that line has been implemented without losing any business.

Robert Parker, president of the Wilkerson Company, was discussing operating results in the latest month with Peggy Knight, his controller, and John Scott, his manufacturing manager. The meeting among the three was taking place in an atmosphere tinged with apprehension because competitors had been reducing prices on pumps, Wilkerson’s major product line. Since pumps were a commodity product, Parker had seen no alternative but to match the reduced prices to maintain volume. But the price cuts had led to declining company profits, especially in the pump line (summary operating results for the previous month, March 2000, are shown in Exhibits 1 and 2).

Wilkerson supplied products to manufacturers of water purification equipment. The company had started with a unique design for valves that it could produce to tolerances that were better than any in the industry. Parker quickly established a loyal customer base because of the high quality of its manufactured valves. He and Scott realized that Wilkerson’s existing labor skills and machining equipment could also be used to produce pumps and flow controllers, products that were also purchased by its customers. They soon established a major presence in the high-volume pump product line and the more customized flow controller line.

Wilkerson’s production process started with the purchase of semi-finished components from several suppliers. It machined these parts to the required tolerances and assembled them in the company's modern manufacturing facility. The same equipment and labor were used for all three product lines, and production runs were scheduled to match customer shipping requirements. Suppliers and customers had agreed to just-in-time deliveries, and products were packed and shipped as completed.

Valves were produced by assembling four different machined components. Scott had designed machines that held components in fixtures so that they could be machined automatically. The valves were standard products and could be produced and shipped in large lots. Although Scott felt several competitors could now match Parker's quality in valves, none had tried to gain market share by cutting price, and gross margins had been maintained at a standard 35%.

The manufacturing process for pumps was practically identical to that for valves. Five components were machined and then assembled into the final product. The pumps were shipped to industrial product distributors after assembly. Recently, it seemed as if each month brought new reports of reduced prices for pumps. Wilkerson had matched the lower prices so that it would not give up its place as a major pump supplier. Gross margins on pump sales in the latest month had fallen below 20%, well below the company's planned gross margin of 35%.

Flow controllers were devices that controlled the rate and direction of flow of chemicals. They required more components and more labor, than pumps or valves, for each finished unit. Also, there was much more variety in the types of flow controllers used in industry, so many more production runs and shipments were performed for this product line than for valves. Wilkerson had recently raised flow controller prices by more than 10% with no apparent effect on demand.

Wilkerson had always used a simple cost accounting system. Each unit of product was charged for direct material and labor cost. Material cost was based on the prices paid for components under annual purchasing agreements. Labor rates, including fringe benefits, were $25 per hour, and were charged to products based on the standard run times for each product (see Exhibit 3). The company had only one producing department, in which components were both machined and assembled into finished products. The overhead costs in this department were allocated to products as a percentage of production-run direct labor cost. Currently, the rate was 300%. Since direct labor cost had to be recorded anyway to prepare factory payroll, this was an inexpensive way to allocate overhead costs to products.

Knight noted that some companies didn’t allocate any overhead costs to products, treating them as period, not product, expenses. For these companies, product profitability was measured at the contribution margin level ! price less all variable costs. Wilkerson’s variable costs were only its direct material and direct labor costs. On that basis, all products, including pumps, would be generating substantial contribution to overhead and profits. She thought that perhaps some of Wilkerson’s competitors were following this procedure and pricing to cover variable costs.

Knight had recently led a small task force to study Wilkerson’s overhead costs since they had now become much larger than the direct labor expenses. The study had revealed the following information:

1. Workers often operated several of the machines simultaneously once they were set up. For other operations, however, workers could operate only one machine. Thus machine-related expenses might relate more to the machine hours of a product than to its production-run labor hours.

2. A set-up had to be performed each time a batch of components had to be machined in a production run. Each component in a product required a separate production run to machine the raw materials or purchased part to the specifications for the product.

3. People in the receiving and production control departments ordered, processed, inspected, and moved each batch of components for a production run. This work required about the same amount of time whether the components were for a long or a short production run, or whether the components were expensive or inexpensive.

4. The work in the packaging and shipping area had increased during the past couple of years as Wilkerson increased the number of customers it served. Each time products were packaged and shipped, about the same amount of work was required, regardless of the number of items in the shipment.

Knight’s team had collected the data shown in Exhibit 4 based on operations in March 2000. The team felt that this month was typical of ongoing operations. Some people recalled, however, that when demand was really heavy last year, the machines had worked 12,000 hours in a month and the factory handled up to 180 production runs and 400 shipments without experiencing any production delays or use of overtime.

Exhibit 1 Wilkerson Company: Operating Results (March 2000)

Sales $2,152,500 100%

Direct Labor Expense 271,250

Direct Materials Expense 458,000

Manufacturing overhead

Machine-related expenses $336,000

Setup labor 40,000

Receiving and production control 180,000

Engineering 100,000

Packaging and shipping 150,000

Total Manufacturing Overhead 806,000

Gross Margin $617,250 29%

General, Selling & Admin. Expense 559,650

Operating Income (pre-tax) $ 57,600 3%

Exhibit 2 Product Profitability Analysis (March 2000)

Valves Pumps Flow Controllers

Direct labor 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

TOTAL $56.00 $70.00 $62.00

Target Selling Price $86.15 $107.69 $95.38

Planned Gross Margin 35% 35% 35%

Actual Selling Price $86.00 $87.00 $105.00

Actual Gross Margin 34.9% 19.5% 41.0%

Exhibit 3 Product Data
Product Lines	Valves	Pumps	Flow Controllers
Materials per unit	7components	5components	10 components
	2@$2 = 4	3@$2 = 6	4@$1 = 4
	2@$6 = 12	2@$7 = 14	5@$2 = 10
			1@$8 = 8
Materials cost per unit	$16	$20	22
Direct labor per unit	.40 DL hours	.50 DL hours	.40 DL hours
Direct labor $/unit @ $25/DL hour	$10	$12.50	$10.00
(including employee benefits)
Machine hours per unit	0.05	0.05	0.03

Exhibit 4 Monthly Production and Operating Statistics (March 2000)

Exhibit 4 Monthly Production and Operating Statistics (March 2000)				Total
	Valves	Pumps	Flow Controllers
Production Units	7500	12500	4000	24000
Machine Hours	3750	6250	1200	11200
Production runs	10	50	100	160
# of shipments	10	70	220	300
hours of engineering work	$250	$375	625	1250

Answer 1

Existing cost system of Wilkerson's is the traditional volume based costing that is direct material and labor cost are based on standard price of material and labor rates. The manufacturing overhead is allocated in proportion to direct labor cost at the rate of 300% (based on assumption that there's direct relationship between volume of production and level of overhead).

Product	Valves	Pumps	Flow Controllers	Total
Number of units	7500	12500	4000	24000
Direct Labor	75000	156250	40000	271250
Direct Material	120000	250000	88000	458000
Total Direct Cost	195000	406250	128000	729250
Overhead Cost (300% 0f Direct labor)	225000	468750	120000	813750
Total Cost allocation	420000	875000	248000	1543000

Volume of production output are not in proportion with the volume of production, the cost system at the moment Wilkerson using an inappropriate method that leads to wrong assumption when analyzing the profitability and hence, lead to wrong pricing decisions. Activity based costing helps to find the real relationship between the volume of production of product and the overhead. First, it is necessary to define cost pool and find the drivers.

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
Set up labor	40,000	Production runs	160 production runs	$250 per production run
Receiving and production control	180,000	Production runs	160 production run	$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

Calculation of Activity Based Cost per product -

Product	Valves	Pumps	Flow Controllers
Units	7500	12500	4000
Direct Material	120,000	250,000	88,000
Direct Labor	75,000	156,250	40,000
Total Direct Cost	195,000	406,250	128,000
Manufacturing Overheads:
- Machine related expenses (WN1)	112,500	187,500	36,000
-Set up labor (WN2)	2,500	12,500	25,000
-Receiving and production control (WN3)	11,250	56,250	112,500
-Engineering (WN4)	20,000	30,000	50,000
-Packaging and shipping (WN5)	5,000	35,000	110,000
Total Manufacturing Overheads	151,250	321,250	333,500
Total Cost	346,250	727,500	461,500

Working Notes:

1. Machine related expenses:

Valves = 3750 * $30 = $112,500

Pumps = 6250 * $30 = $187,500

Flow Controllers = 1200 * $30 = $36,000

2. Set up labor:

Valves = 10 * $250 = $2,500

Pumps = 50 * $250 = $12,500

Flow Controllers = 100 * $250 = $25,000

3. Receiving and production control:

Valves = 10 * $1,125 = $11,250

Pumps = 50 * $1125 = $56,250

Flow Controller = 100 * $1125 = 112,500

4. Engineering:

Valves = 250 * $80 = $20,000

Pumps = 375 * 80 = $30,000

Flow Controller = 625 * 80 = $50,000

5. Packaging and shipping:

Valves = 10 * 500 = $5,000

Pumps = 70 * 500 = $35,000

Flow Controller = 220 * 500 = $110,000

Total Cost per unit:

Valves = 346,250 / 7500 = $46.17

Pumps =  727,500 / 12500 = $58.2

Flow Controller = 461,500 / 4000 = $115.38

Comparing between the costing system:

Method	Existing Cost System			Activity-Based Costing
Product	Valves	Pumps	Flow Controllers	Valves	Pumps	Flow Controller
Units Produced	7500	12500	4000	7500	12500	4000
Standard unit cost	$56	$70	$62	$46.17	$58.20	$115.38
Planned Gross Margin	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	$87	$105	$86	$87	$105
Actual Gross Margin	34.9%	19.5%	41%	46.3%	33.1%	-9.9%

From above table we can see that Valves have higher gross margin and also Pumps have higher gross margin while flow controllers have a negative gross margin.

The calculations gives more accurate information about the actual production costs by using cost drivers. In Exhibit 2 gross margin for Valves is 34.9%, Pumps is 19.5% and for Flow controller is 41%. And by looking Activity based costing Valves and Pumps are more attractive for the company.

The cost calculations are sensitive to the utilization of the product line. Based our numbers on the information of March 2000, which is mentioned as a typical month but it is also mentioned that on months of high demand machines worked 12,000 hours in a month, factory handled up to 180 production runs and 400 shipments.

If we based on past years demand charts including seasonal shifts in demands, the cost calculations would be best achieved. The cost of the material and labor can also change during time and should be updated for accurate cost calculation.