Wilkerson Company Case Study

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Background

Wilkerson Company is a medium-sized manufacturing enterprise for water purification system. It specialized in producing three alternative products-valves, pump and flow controller. In terms of these three products, pumps as a commodity and high-volume product, has a high price competition, which reflects price cutting by rival resulted in a decline of the company’s pretax profit to under 3%. Valves are unique design products with high quality in the industry, obtaining a loyal customer base. Flow controller are customized products which have a high cost. Currently, the company objective is to maintain a gross margin at a standard 35%. The cost system used in company assume that the overhead costs were allocated to products in relation to the labor costs at 300% rate, and the company believe that this is a less costly way.

Problems and Issues

The main problem existing in company is the decline in profits. The overall pre-tax margin has dropped from a historical rate of 10% to less than 3%. There are three critical issues related to the problem. Firstly, the cost accounting system is overly simply that cause inappropriately allocated on overhead cost. Secondly, inaccurate cost allocating method misleads pricing decision, which contribute to underpricing and eventually lose profit. Lastly, inappropriate cost system leads to overvaluation, thereby causing the risk of losing market share and market competitiveness.

Analysis

The manufacturing overhead was currently calculated based on direct labour costs multiply by 300% rate, which means MOH costs increases as direct labour. This cost system would not reflect the real costs incurred when including different activities. For example, machine-related expenses were related machine hours rather than direct labour. ABC analysis considered the real activities occurred in the manufacturing overhead (machine-related expenses, set up labour,etc), and allocate resources with different cost drivers. This method is more effective for pricing product and avoids instance of undervaluation and overvaluation. In specific, from table 4, cost-volume method described that pumps has the lowest actual gross margin (19.5), which is far blew the target (35%).The reason for that is the actual selling price (87) fail to recover the high cost (70). However, through the ABC analysis, the total costs for pumps is relatively small( 58) and the actual profit margin is 33%. This shown that the actual gross margin is near balance with the target rate

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even though the actual sale price of pump was lower than the target price due to cooperate with the market price. We can conclude that the MOH cost of pumps was overestimated, and thereby pumps is not the reason for the decline in profits. Moreover, the table 4 also reveal that flow controllers had the highest margins of 41%, which seems as the most profitable. While examining the ABC approach, we can see that the costs (115) is much larger than the result (62) on the basis of the traditional cost method. This situation would possibly result from more production runs and more shipments were performed to process flow controller than pumps or valves:thereby, for flow controller, the MOH costs should have classification calculation based on different activities rather than purely depend on volume.The product actually generate a gross margin of -10%.Although the actual selling price(105) has exceed the target price(95.38), it can not offset the high cost(115);therefore,the gross margin of 41% using cost-volume system is inaccurate. From here we can conclude that the cost of flow controllers was undervaluated, which helps to response the decrease in profits.Furthermore,through allocating the overhead costs in ABC approach, valves are the product with the highest margins,at 46%.

According to the calculation of the percentage change in total manufacturing overhead costs,it can be observed that there is a change of 177.93% in overhead costs, which also explain the decreasing profit.

In addition,as shown in table 3,the total MOH costs are $813750 basis of cost-volume method, while it is $806000 in the ABC analysis. This proves that there is $7750 was over-allocated.Therefore, a high manufacturing overhead lead to a decline in the net operating income.

In conclusion, the MOH costs of pumps and valves is lower when applying activity-based costing system, and both of them have higher gross profits using ABC method than simple cost system.In contrast,flow controllers has higher MOH cost and its gross margin is lower when using ABC. Hence,we can conclude that the simple cost system would lead to price overvaluation and undervaluation, while ABC analysis gives a more accurate outcome when allocating manufacturing overhead costs in terms of different activities.

Recommendation

The company should alter to an activity-based costing system which can ensure the pricing accuracy.

For flow controller, the actual gross margin was -10% in ABC analysis so that it caused profit drop.There are two suggestions for this products.One side is to eliminate the flow controller.,From the table 6,assume to close the flow

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controller production line, we can see that the gross margin increased from 617250 to 658750, rose by nine percent,and pre-tax operating income increased by 3%.This profit growth also able to remedy for the decrease in the price of valves and pumps due to the increased competition.However, the drawback of this method is that there will be lose some customers and more heavily rely on pump and valves profitability.Another piece of advice is that the company could adjust the price of the flow controller in line with the ABC cost method, while remaining the target gross profit at 35%.From the table 6,it revealed that the new price of flow controller should be no less than $178, which the gross margin would probably achieve at 35%.The advantage of adjusting the price is it creates a positive profit margin,and also enhanced efficiency. However,an increase in price also may lead to a negative effect, which reflects on the potential change in demand.The company would thus lose some loyal customers.

In addition,through analysis,due to the high quality and unique design, valves still have a better profit,so the company do not need to change the price of valve.

Pump is a commodity product and has a fierce competition market,so the company should adjust the sale price based on manufacturing cost, to prevent loss profit when market price drops.

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For flow controllers: cost- volume system MOH=120000

Percentage change: Flow Controllers=(333500-120000)/120000=177.92% Table 5

Table 6

Adjust FC sale price is 178 per unit,and the gross margin is 37%

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