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Wilkerson Company Argumentative

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The analysis below is related to Wilkerson Company, which is a manufacturer of a few products supplied to manufacturers of water purification equipment. The three products they manufacture are: 1. Valves- high quality and highest tolerances in the industry; this product is what the company started from. 2. High-volume pumps- quickly became a major supplier of pumps; they manufacture and spend more machine hours on producing this product 3. Flow controllers- most unique and highest selling product. Wilkerson Company would like to be making 35% gross margin on all three products, but the competitors have continually lowered the prices of their pumps. This forced Robert Parker (President of Wilkerson Company) to also lower the company’s price of pumps to maintain volume and status as a major supplier. Unfortunately, this has brought the gross margin for pumps DOWN (below 20%). Wilkerson Company’s competitive situation is to continue competing in the manufacturing of pumps while meeting planned gross margins of 35%. Wilkerson needs accurate product costing to achieve gross margin goals as well as support both the internal and external shareholders that depend on this information.

Wilkerson has defined goals for gross margins and in order to hit these, they need to understand their production cost and correct assignment of overhead. This will allow them to determine which products are high margin and should be emphasized in the market. It also allows them to address competitor price moves with confidence. For example, Wilkerson may determine lowering prices and entering a price war is not-advisable if they have a strong customer base and if eroding the margins will threaten the overall business. Likewise, Wilkerson needs accurate cost information to identify opportunities to margins as they did with flow controllers without losing business. Accurate cost knowledge can also help determine indirect resource use and identify areas for investment and improvement. There are also a number of internal and external stakeholders impacted by cost knowledge accuracy. Examples of internal parties impacted by cost accuracy are as follows: Accounting: Responsible for assigning costs and reconciling between actual and normal costing.

Pricing: Looks to cost of goods produced to ensure that they are pricing product appropriately to achieve margin goals. Operations: Need to understand how indirect costs are assigned and responsible for improving efficiency and reducing costs. Management: Dependent upon accurate cost information to make decisions that impact all facets of the company, External parties also impacted by the cost knowledge are described below: Investors: Concerned with profitability which is driven off cost of goods sold. Customers: End price may be determined by the allocation of production costs. Wilkerson has always used a simple cost accounting system to assign costs to each product line. Wilkerson has historically used this approach because direct materials and direct labor were already tracked and easy to assign to each product. Wilkerson’s production department’s overhead was then applied at a rate of 300% of the direct labor hours assigned to each product. Since Wilkerson adopted this model, overhead costs have grown to be a much more significant cost driver than direct labor.

This trend has been seen across the business environment due to a greater focus on customization, services, R&D, and advanced technology. This last point is especially important as companies have moved to more robots and capital investment to improve capacities and reduce direct labor hours. As a result, direct labor hours are not necessarily representative of the overhead required for each product line. This is supported by Wilkerson’s analysis which found the following: Often multiple machines were operated simultaneously by a single operator while sometimes only a single machine could be operated. Each machined component required set-up time not reflected in the direct labor. Indirect labor time in receiving, production control, and shipping was constant regardless of the product. Shipping time was variable by the number of shipments, not the number of products shipped.

While activity based costing (ABC) systems have not been adopted by all companies, it would be beneficial for Wilkerson to consider using ABC costing for the three product lines they produce. With overhead costs as a significant cost contributor, Wilkerson should categorize production department overhead costs into subsets that can be applied more accurately using a combination of machine hours, direct labor hours, and run/shipment quantities. ABC costing has been utilized by manufacturing companies looking to address the greater influence overhead has on cost as a result of increased capital investment and indirect labor. For example, at PACCAR, activity based costing allocates overhead to identify kitting and simple assembly cells that can be moved into local third party vendors. Under the activity-based costing system, Wilkerson is more profitable with the manufacturing of valves with a 46.3% margin and pumps with a 33.1% margin (see Exhibit 2).

On the contrary, flow controllers that were at a 41% margin under traditional, volume-based costing have now declined substantially to -9.9% under ABC (see Exhibit 2). This shift is a result of better correlated cost drivers amongst the different cost pools in the Wilkerson Company. For example, the different cost pools as shown in Exhibit 1 of the case are: machine-related expenses, set up labor, receiving and production control, engineering, and finally packaging and shipping. Under the traditional, volume-based costing system the assumption was that there was a direct relationship between production volume per product and level of overhead using direct labor costs at a rate of 300%. The assumption using activity-based costing is to appropriately assign overhead costs amongst the 3 product lines. It is determined that the cost drivers to assign are: machine hours, production runs, number of shipments, and hours of engineering work. In doing this, the company reveals the cost distortion for each product line with the most alarming distortion being the under-costing of the Flow Controllers for a total of -$213,520 (see Exhibit 2).

In Peggy Knight’s studies, she determined that the company’s operations in March 2000 were indicative of typical ongoing operations. However, in the previous year the company experienced high demand and was able to operate without production delay or overtime. Using the data collected from a month of high demand last year with a max capacity of 12,000 machine hours, 180 production runs and 400 shipments may provide differences in machine related expenses however it does not depict seasonal demand that may be experienced throughout the course of a year. It would be better to use data collected over the course of a year in past years rather than one particular month of high demand and the month of March 2000 as demonstrated in the case. When using the max capacity levels the activity-based cost rates go down, for example $28 per machine hour, $222.22 per production run, and $375 per shipment. Additionally, activity cost per unit of production is the same across the product lines at $14 (see Max Capacity Levels Table) where it varied amongst the product lines previously. This information may have a behavioral effect on management resulting in poor decisions.

However in this example, the total machine-related costs are higher for the flow controllers and lower for the valves and pumps which is closely related to the cost determined under ABC. Therefore, in this instance any behavioral decisions may not be negative because the results still prove that the flow controller has not been profitable to produce in the manner in which they had been under the traditional, volume based costing method. Implementation of the new costing system should be presented to management. With the data provided the selling price of the flow controller could be increased to offset the loss of margin from under-costing the units by -$53.38. Additionally, with no loss of business given the previous 10% price increase in flow controllers the market should not react to another slight increase. Management also has the opportunity to be more competitive in pricing, with respect to the analysis of pumps and valves. In doing so, they can increase market share in valves and regain the market share as a major pump supplier. With the manufacturing process for pumps and valves being so similar this would be a win-win in maximizing overhead costs.

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