Wilkerson Case
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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
156,250
40,000
Direct Material
120,000
250,000
88,000
Total Direct Costs
195,000
406,250
128,000
Manufacturing Overheads
225,000
468,750
120,000
Total Cost Allocation
420,000
875,000
248,000
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:
Identify and define cost pools and cost drivers
Directly trace costs to activities (to the extent feasible)
Assign costs to activity cost pools
Calculate activity rates
Assign costs to cost objects using the activity rates and activity measures previously determined
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 =$30 per machine hour for the cost of activity.
Table 2: Manufacturing Overhead
Cost Pool
Amount ($)
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
156,250
40,000
Direct Material
120,000
250,000
88,000
Total Direct Costs
195,000
406,250
128,000
Manufacturing Overheads
– Machine Related Expenses
112,500
187,500
36,000
– Setup labor
2,500
12,500
25,000
– Receiving and production control
11,250
56,250
112,500
– Engineering
20,000
30,000
50,000
– Packaging and shipping
5,000
35,000
110,000
Total Manufacturing Overheads
151,250
321,250
333,500
Total Cost Allocation
346,250
727,500
461,500
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 companys 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 companys 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