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 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 225,000 54%468,750 54%120,000 48% Total Cost Allocation420,000 100%875,000 100%248,000 100% 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: 1. Identify and define cost pools and cost drivers 2. Directly trace costs to activities (to the extent feasible) 3. Assign costs to activity cost pools 4.
Calculate activity rates 5. Assign costs to cost objects using the activity rates and activity measures previously determined 6. 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 =$30 per machine hour for the cost of activity. ] Table 2: Manufacturing Overhead
Cost PoolAmount ($)Cost DriverAmountActivity-Based Cost Rate Machine Related Expenses 336,000Machine hours 11,200 machine hours$30 per machine hour Setup labor 40,000Production runs160 production runs$250 per production run Receiving and production control 180,000Production runs160 production runs$1,125 per production run Engineering 100,000Hours of engineering work 1,250 engineering hours$80 per engineering hour Packaging and shipping 150,000Number of shipments300 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 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% Manufacturing Overheads – Machine Related Expenses 112,500 32%187,500 26%36,000 8% – Setup labor 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 Overheads151,250 44%321,250 44%333,500 72% Total Cost Allocation346,250 100%727,500 100%461,500 100% 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 company’s 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 company’s 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 TACABC
ValvesPumpsFlow ControllersValvesPumpsFlow Controllers Unit Produced 75001250040007500125004000 Standard Unit Cost $56. 00$70. 00$62. 00$46. 17$58. 20$115. 38 Planned Gross Margin35%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$105. 00 Actual Gross Margin34. 9%19. 5%41. 0%46. 3%33. 1%-9. 9% By incorporating the operating result in the next page, it indicates the gross margin of 35% has been achieved and the pre-tax operating income has been increase from 3% to 11%.
The reason of going up is not because of increase in profit, but due to the re-calculating the cost and revenue by using different costing method which is relatively close to the reality. Therefore, ABC provides ‘visibility’ for managers who can understand the real costing in each manufacturing activities involved, they can establish clear-cut cause-and-effect relationships between activities and costs. Table 5: Operating Result (March 2000) TACABC ($)($) Sales 2,152,500 100%2,361,923 100%
Direct Labor Expense 271,250 271,250 Direct Materials Expense 458,000 458,000 Manufacturing Overhead 806,000 806,000 Gross Margin617,250 29%826,673 35% General, Selling and Administration Expense 559,650 559,650 Operating Income (pre-tax)57,600 3%267,023 11% For deep analysis of the distribution of overhead costs under ABC system, we can easily get the numbers of each costing activities which included direct labor and material costs, total manufacturing overheads and total cost allocation in each products.
As we see Table 4 below, we discovered that the higher costs incurred in each products are clearly shown such as the greater expenses of the production in Pumps are the machine related expenses and direct labor costs which have taken up 56% and 58% respectively of such total expenses, whereas Flow Controllers taken up 62% each in setup labor and receiving and production control costs respectively.
Therefore, Wilkerson Company can set strategic products planning efficiently and effectively based on these costing structures. Table 6: Distribution of Overhead Costs Valves ($)Pumps ($)Flow Controllers ($)Total ($)? Direct Labor 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% Manufacturing Overheads Machine Related Expenses 112,500 33%187,500 56%36,000 11%336,001 100% – Setup labor 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 Overheads151,250 19%321,250 40%333,500 41%806,002 100% Total Cost Allocation346,250 23%727,500 47%461,500 30%1,535,251 100% After examining the costing structures in TAC and ABC systems, we can differentiate these two costing methodologies in terms of advantages and disadvantages.
For the TAC, firstly, it is relatively easier to manage since it mainly takes the direct labor cost into account in considering cost allocation in production process; however, there are different types of industries with the needs of requiring different cost structure so as to provide an accurate company data in use, especially if a large company have variety of products and services which obviously have different labor and other costs allocation in each activity, so TAC could not provide a real picture on cost allocation which causes managers could not make the appropriate decision based on such costing method .
Secondly, TAC is quite ideal for the mass produced products which requires labor intensive process, but not sufficiently flexible to accommodate different production situations as we just mentioned. Since products required to be ever changing to meet the needs of customers in order to be more competitive in the market. At this point, TAC cannot be compatible with the changing needs of customers on different needs of cost allocation under severe competitive environment.
In contrast to the TAC, ABC systems are not inherently constrained by the tenets of financial reporting requirements. Rather, ABC systems have the inherent flexibility to provide special reports to facilitate management decisions regarding the costs of activities undertaken to design, produce, sell, and deliver a company’s products or services. Also, ABC method is ideal for large companies since it provides knowledge for separating the selling of high-volume products with few complexities in production from low-volume products with more complexities in production.
With knowing the cost in each production activity, managers can customise different market situations so that the company can identify which products are most profitable and where to focus sales efforts. However, the setting of cost drivers may not fully explain the cost behaviour because of the selection and coordination appropriateness may varies from subjective preferences or company culture. The main learning outcome from analyzing the above information about Wilkerson Company is manufacturing overhead cost allocation.
To improve the accuracy of the manufacturing overhead cost allocation, the company should adopt the Activity-Based Costing (ABC) method as the current cost system does not reflect the market behaviour that fit with product profitability as we mentioned before. Furthermore, Wilkerson’s product lines are different in nature and delivery process. From the Monthly Production and Operating Statistics (March 2000), it clearly shows that the manufacturing process for flow controller has more activities compared to valve and pump.
For example, to produce 4,000 units of flow controller, we need to consume 100 production runs and 625 hours of engineering work. However, with 50% of the production runs and 60% of the engineering work of flow controller’s overhead resources, the company can produce 12,500 units of pumps. Besides that, flow controller also has a highest number of shipments per month compared to pump and valve.
Also, the distribution of manufacturing overheads to the total cost ratio is much greater than the direct labor to total cost ratio which means the TAC system cannot provide accurate cost information to the managers since it mainly takes the labor cost into account. Lastly, the required percentage of pre-tax margin (10%) can be achieved if under ABC system (11%). Therefore, we suggest switching from TAC to ABC approach which focuses on the activities required to produce each product and allocates cost based on that product’s consumption of those activities.
In addition, Wilkerson has a group of loyal customer base for their Valves and major product line of Pumps sustaining in market. Also, the gross margin of Valves ad Pumps both achieved the required rate at 35% under ABC system, as well as there are reduction in cost for both Valves (17. 55%) and Pumps (16. 86%). Therefore, both in operational and market strategy, Valves and Pumps are suggested to maintain the existing price at $86 and $87 respectively. However, there is an increase in cost of producing Flow Controllers (86. %) under ABC system, there will be an option for management decision on whether keep the production line of Flow Controllers because its actual gross margin is at -9. 9% which far below the required rate. If they close down the flow controllers, they can spread the production cost to the other relatively profitable products or looking for other new opportunities. However, we cannot make sure the alternative opportunities can perform better than flow controllers.
Instead, if we keep continuing the production, we must think about the reduction in cost and better overhead management so as to increase the gross margin. At this point, we can pressure on the salesperson to close more deals to compensate the low volume cost. For example, with more demand on flow controllers, then we can negotiate a better deal from logistic company on the cost of shipments. As Wilkerson raised the price previously by more than 10%, we can think about the range from 10%-35% in order to compensate the required rate of 35% of gross margin.
Of course, more value added service may be required at such price so as to reduce any effects on demand. In summary, we know that Robert Parker is facing an issue of cost misallocation on the production lines. Since the company using the traditional absorption costing (TAC) in which costs are accumulated in a pool and then allocated to specific products based on a single, plant-wide base, such as direct labor hours utilized in producing the product. However, such method brings to the wrong company data on gross margin and pre-tax operating income.
If Wilkerson still keeps using TAC, managers will be easily misled by the existing cost report, so that the senior management may not be able to have a real picture on making the correct decision towards the business planning. In light of this, the advice of recommending Activity-based Costing (ABC) instead is mainly tackle the existing costing issue because ABC allocated staff and overhead costs to products based on how the products actually consumed or generated the costs. In ABC, there are cost drivers, i. e. osts are driven up or down by these factors such as using units of production, labor hours, machine hours, floor space used, production runs, number of shipments, hours of engineering work and sales costs as drivers. Since we have all these relevant drivers that designed to provide more accurate information about production and support activities and product costs so that management can focus its attention on the products and processes with the most leverage for increasing profits. It helps managers make better decisions about product design, pricing, marketing, and mix and encourages continual operating improvements.
In this case, we suggest to keep the existing production of Valves and Pumps because they have stable demand and relatively produce in large volume , whereas the cost of shipping and packaging as well as the engineering overhead are obviously greater than the other 2 products, so we need to focus on the decision making on Flow Controller whether close down the production line or keep it with decrease in its costing on shipment by looking for other cheaper logistics company or increase the percentage of price rate by incorporate with more customer services to reach the gross margin at 35%.