wilkerson accounting case

Competitive Situation

1. What is the competitive situation faced by Wilkerson?

The approach to this question was:

• Identify competitive factors from the external environment

• Link the external factors directly to internal impact

• Understand how each internal impact affects the financial implications

This is illustrated in the table on the next slide.

External Environment Internal Impact Financial Impact

Competitors have been reducing price on pumps

A decrease in profits due to price cutting in pumps

Pre-tax margin currently less than 3%, with a historicalaverage of 10%.

Reduction in gross margin 19.5%.

Commodity products competeon price and volume

Pumps are the most costly to produce but receive the lowest margin. Thus difficult to increase the margins on pumps.

$20 difference in actual selling price to that which is required.

Competitors overlooking the opportunity for profits to be made on flow controllers

Wilkerson increased flow controller prices by 10% without loosing demand.

Gross margin on flow controllers increased to 41%, which exceeded the planned gross margin target.

Flow controllers need to be the most customised

The overall production and distribution of flow controllers is understood to be the most resource intensive.

The current volume based costing method does not reflect the resource intensive nature of flow controllers e.g. the standard unit cost of flow controllers is $62 which is lower than pumps which has a unit cost of $70 even though it is less intensive to manufacture.

Valves are less sensitive to a commoditised markets in comparison to pumps

Valves are a standardised product and thus can be machine automated.Additionally these can be produced and shipped in large lots benefitting from economies of scale.

Due to being less sensitive to commoditised markets, Wilkerson can maintain a higher price and thus meet their projected margins.

Due to standardising the product, Wilkerson has low standard unit costs in valves at $56.

Apparent problems with current cost system

2. Given some of the apparent problems with Wilkerson’s cost system, should executives abandon overhead assignment to products entirely by adopting a contribution margin approach in which manufacturing overhead is treated as a period expense? Why or why not?

The approach to this question was to:

• Understand current problems in the system by treating manufacturing costs as a period cost

• The advantages of adopting a contribution margin approach

• Comparison between traditional income statement and contribution income statement

This is outlined on the next slides.

Wilkerson should adopt a contribution margin approach but not in which manufacturing overhead (MOH) is treated as a

period expense.

Current problems in the system by treating manufacturing costs as a period cost

• Manufacturing overhead is estimated by multiplying direct labour with 300%. This estimation is not accurate and does not

represent how the actual variable sub-costs that compose the MOH behave i.e. machine related expenses, setup labour,

receiving and production control, engineering, packaging and shipping. Although there could be a relationship between

the amount of direct labour cost and the total MOH, this current method of estimation is vague and disregards the actual

components of MOH.

Advantage of product cost

• More precise reflection of the variability of the sources e.g. if there are five variables, it is more accurate than having one.

Advantage of period cost

• Treating MOH as a period cost means that it remains easier to compare Wilkerson’s with a competitor, provided that

competitor also treats MOH as a period cost i.e. it is easier to compare like-for-like.

Advantages of adopting a contribution margin approach

• The contribution margin approach separates fixed and variable costs which cannot be normally seen on a traditional

income statement (Gowthorpe, 2003).

• Wilkerson should adopt a contribution approach because they are a company with three products and it is useful to

understand the variable expenses that can be attributed to each product. Thus the company can understand which costs

increases if production increases. In a traditional income statement approach, it is difficult to determine which costs

belong to increasing productivity whereas this is much easier in a contribution margin approach (Collier, 2006).

• A contribution margin statement would be required if Wilkerson wanted to conduct further analysis such as target profit

analysis, break-even and margin of safety (Atrill & McLaney, 2006). Also for internal calculations the contribution approach

would help determine cost-volume analysis, including CM ratio and variable expense ratio for example.

Traditional Income Statement

Contribution Format Income Statement

Current Cost System Operating Model

3. How does Wilkerson’s existing cost system operate? Develop a diagram to show how costs flow from factory expense accounts to products.


• Illustrate a process flow diagram of the current system

• Show how cost assignments are calculated in the current system

Production Department

Valves PumpsFlow

Controllers

MOH Cost Assignment

($30)

MOH Cost Assignment

($37.50)

MOH Cost Assignment

($30)

Finished Products

Selling, General & Administrative

Expenses

Direct Labour

1) Currently, direct labour costs were used to assume manufacturing overheads (MOH) i.e. if direct labour increases, so does manufacturing overhead. This cost assignment process therefore does not reflect the real costs incurred as opposed to when all the different activities are taken into account. For example, the machine related expenses were not related to machine hours but rather related to direct labour.

2) This is therefore the incorrect cost allocation; e.g. for flow controllers where direct labour per unit is $10 (the lowest out of all products), they assume manufacturing overhead per unit is $30 (300% x $10) (see next slide for breakdown).

Process flow diagram of current system

Cost Assignment (Valves)

Cost Assignment (Pump)

Cost Assignment (Flow

Controllers)

How cost assignments are calculated in the current system

Direct Labour per unit ($10)

Direct Material per unit ($16)

Manufacturing Overhead per

unit ($30)

$75,000 $120,000 $225,000

x 300%

Direct Labour per unit ($12.50)


Manufacturing Overhead per unit ($37.50)

$156,250 $250,000 $468,750

x 300%

Direct Labour per unit ($10)


Manufacturing Overhead per

unit ($30)

$40,000 $88,000 $120,000

x 300%

Units Produced: 7,500



In the current system, direct labour, direct material, and MOH are calculated by taking the number of units produced andmultiplying it by cost per unit. MOH per unit is calculated by assuming 300% of direct labour per unit.

Activity-based cost model

4. Develop and diagram an activity-based cost model using the information in the case. Provide your best estimates about the cost and profitability of Wilkerson’s three product lines. What difference does your cost assignment have on reported product costs and profitability? What causes any shifts in cost and profitability?

The approach to answering this question includes:

• Process flow diagram of how ABC should take place within the entire process

• How manufacturing overhead is calculated under ABC

• Identification of new profit margins under ABC and comparison with CVP ones

• Calculate changes in MOH between the two models

• Understand how those changes impact gross margins

• Link any additional factors that might influence results

• Graphs comparing CVP and ABC cost calculations

Production Department

Find Activities

Machine related

expensesSet up labour

Process flow diagram for ABC

Receiving and production

controlEngineering

Packaging and shipping

Machine hours

Production Runs

Production Runs

Hours of Engineering

Work

Numbers of Shipments

Calculate Manufacturing

Overhead

Finished Products

SG&A

Activities

ABC

Once activities were defined, manufacturing overhead can be calculated using ABC. The next slide breaks down the individual calculations.

Manufacturing Overhead

Machine related expenses

Set up labourReceiving and

production controlEngineering

ABCCVP ABCCVP ABCCVP ABCCVP

336,000

112,500

187,500

36,000

336,000 40,000

2,500

12,500

25,000

40,000 180,000

11,250

56,250

112,500

180,000

20,000

100,000

30,000

50,000

100,000

How manufacturing overhead is calculated under ABC

Pumps

Valves

The above diagram shows the key disadvantage of CVP costing i.e. although a total product cost can be calculated, the cost of activities cannot be attributed to individual products.

Product totals

CVP ABC

468,750

225,000

120,000FCs

Totals

151,250

321,250

333,500

Packaging and Shipping

ABCCVP

5,000

NO ALLOCATION

145,000

35,000

110,000

145,000

NO ALLOCATION

NO ALLOCATION

NO ALLOCATION

NO ALLOCATION

Based on the original cost analysis (Exhibit 2), flow controllers had the highest margins at 41%. However, when examiningthe ABC analysis, it can be seen that they are actually generating a gross margin of -9.9%. Along these lines, it can now besaid that valves are the product with the highest margins, at 46.3%.

In the CVP calculations, the company did not take into consideration the difference between direct labour costs and thereal activities in the manufacturing overhead (e.g.: machine time, set up labour, etc.). This is reflected in the ABC modeland might account for the major changes in gross margin. Changes in MOH are explained in the next slide.

Actual Gross Margin using Activity-Based Costing

CVP ABC CVP ABC CVP ABC

Valves Pumps Flow Controllers

Direct labour cost 10.00 10.00 12.50 12.50 10.00 10.00

Direct material cost 16.00 16.00 20.00 20.00 22.00 22.00

New Manufacturing overhead 30.00 20.17 37.50 25.70 30.00 83.38

Standard unit costs 56.00 46.17 70.00 58.20 62.00 115.38

Target selling price 86.15 71.03 107.69 89.54 95.38 177.50

Planned gross margin (%) 35.0% 35.0% 35.0% 35.0% 35.0% 35.0%

Multiplier 1.54 1.54 1.54

Actual selling price 86.00 86.00 87.00 87.00 105.00 105.00

Actual gross margin (%) 34.9% 46.3% 19.5% 33.1% 41.0% -9.9%

ABC vs CVP gross margins

• The percentage change in total MOH was calculated in order to see the difference in the MOH between CVP and ABC.• It can be observed that cost allocation changes between CVP and ABC, especially in the case of flow controllers, for

which there is a change of 177.93% in MOH, which helps explain the negative profit margins for this product.• The graphs on the following slides provide further comparisons.

Changes in Manufacturing Overheads: Cost-Volume Profitability vs. Activity-Based Costing

CVP Analysis


Direct Labour ($) 75,000 156,250 40,000

Direct Material ($) 120,000 250,000 88,000

Manufacturing Overhead ($) 225,000 468,750 120,000

ABC


Direct Labour ($) 75,000 156,250 40,000

Direct Material ($) 120,000 250,000 88,000

Manufacturing Overhead ($) 151,250 321,250 333,500

MOH Unit cost (ABC) ($) 20.17 25.70 83.30

Percentage change in MOH

Valves = 1511,250 - 225,000 = -32.70%225,000

Pumps = 321,250 – 468,750 = -31.46%468,750

Flow Controllers = 333,520 – 120,000 = 177.93%120,000

The following graph was calculated by:

• Multiplying number of units by direct labour cost per unit ($10) (yellow line)

• Multiplying number of units by direct material cost per unit ($16) (orange line).

• Multiplying number of units by MOH cost per unit (300% x DL = $30) under CVP (blue line)

• Multiplying the number of units by MOH cost per unit ($20.17) under ABC (green line)

Conclusion:

By using CVP, the estimated MOH expense is higher than the actual expense calculated by using ABC. Therefore, they have higher gross margins using ABC than calculated using CVP.


• Multiplying number of units by direct labour cost per unit ($12.50) (yellow line)

• Multiplying number of units by direct material cost per unit ($20) (orange line)

• Multiplying number of units by MOH cost per unit (300% x DL = $37.50) under CVP (blue line)

• Multiplying the number of units by the MOH cost per unit ($25.70) under ABC (green line)

Conclusion:

Similarly to valves, the MOH of pumps is higher when applying volume-based costing.The activity-based calculation therefore gives a more accurate result when allocating manufacturing overheads in a company. Therefore, they have higher gross margins using ABC than calculated using CVP.


• Multiplying number of units by direct labour cost per unit ($10) (yellow line)

• Multiplying number of units by direct material cost per unit ($22) (orange line)

• Multiplying number of units by MOH cost per unit (300% x DL = $30) under CVP (blue line)

• Multiplying the number of units by the MOH cost per unit ($83.38) under ABC (green line)

Conclusion:

In this case, the MOH cost for flow controllers is higher when using ABC. However, this is not reflected when using CVP, as the overhead cost is allocated in proportion to direct labour cost.Therefore, gross margins are lower when using ABC than calculated using CVP.

Actions to improve profitability

5. Based on your analysis for Question 4, what actions might Wilkerson’s management team consider to improve the company’s profitability?


• Understand key issues in the current profitability structure• Make recommendations for each product line• Suggest changes to the general profitability approach

Flow controllers:

• As Wilkerson’s main issue lies in a negative gross margin from flow controllers, management must target thisproduct when thinking about profitability improvement. Given that Wilkerson’s recently increased the price by 10%with no impact on demand, meaning it is inelastic, they could continue with this strategy until reaching a price thatwill result in a 35% gross margin ($177.5). For this, they could proceed to do regular 5-10% increases until reachingthe target 69%, always measuring market response and ensuring it will not affect demand. In case it did affect it ata low margin (break-even point to 5%), based on the ABC model, the company might consider discontinuingproduction.

• In addition, the case states that the market is now requesting different flow controllers types and that has asignificant impact on production costs, therefore another strategy for the company could be to segment its maincustomers per order volume and use their requirements to narrow down its type offering based on the top 75% keyaccounts. This would ensure good customer relationships and lower costs simultaneously.

Valves:

• As for valves, although gross margins are higher than the company’s target and they were pioneers in the area,competitors are now able to achieve the same quality levels, so the company could invest part of those proceedingsin R&D to maintain competitive edge.

Pumps:

• As for pumps, Wilkinson is the market leader but has had to match competitor prices, which has caused a decrease ingross margins. The case states margins are under 20% but following the ABC model, they are actually close to the 35%target, at 33%.

• As pumps are a commoditized product, in order to maintain its leading position the company needs to either operateon high volume and low margins, or create some add-on services it can sell to customers. To increase volume, thecompany could offer a discount on larger orders so as to maximize production runs, while packaging and shippingcosts remain the same. They could also identify key accounts and offer specific discounts or create loyalty programs.These could also align with other differentiators such as faster delivery, and special payment plans. More dataregarding current shipping procedures and delivery times would be needed in order to create a more accurate newstrategy proposal.

General:

• A general recommendation is that the company should revaluate the industry average margins and redesign its owntargets based on the results, given that they are selling different product types (commodities vs. customized).Otherwise, management may misallocate company resources or misjudge results.

Limitations to cost estimates

6. What concerns, if any, do you have with the cost estimates you prepared in the answer to Question 4? What other information or analysis would you want for better cost and profitability estimates?

The approach to answering this question includes:

• Identifying concerns and assumptions with the ABC costing

• Identifying other information and analysis required for improved cost and profitability estimates

Concerns and assumptions with ABC costing

Following the activity-based cost estimates obtained in question 4, the concerns and assumptions made are explainedbelow:

• Deciding an allocation base to use for set-up labour - in question 4, an assumption was made that the base toallocate this manufacturing overhead cost were the production runs. Nevertheless, we think that in order to obtaina more accurate cost estimate for this, we should also take into account the components of every product becauseas mentioned in the case “each component in a product required a separate production run to machine the rawmaterials or purchased part to the specifications for the product.”

• The second concern we have is regarding the allocation of the selling and administrative expenses. We assumedthese as fixed. This decision was made to simplify the costing model and also because we did not have anyinformation that would help allocate the expense within the 3 products that the company manufactures. If wewould have had information on where to allocate SG&A within valves, pumps and flow controllers, again, thecosting system would have been even more accurate (e.g. flow controllers might be harder to sell as they are morecustomized so the majority of the SG&A expenses could be allocated to this product, for example, 75% of the totalexpense).

• The last concern we have is regarding the packaging and shipping. The base for this variable cost is solely thenumber of shipments made and the cost for each shipment is $500. We think this is not so accurate given that thesize of the shipment is not being taken into account and the cost of $500 dollars is fixed whether the shipmentinvolves 50 units or 500 units.

Other information/analysis required for improved cost and profitability estimates

We would like the following information and data analysis to improve the cost and profitability estimates:

• Customer information: it would be very useful to have information about key accounts. The company could managekey accounts in more detail and gain loyalty and, therefore profitability in the medium term. Also, customerrequirements in advance could be very helpful as the production department could plan and schedule productions inadvance and gain efficiency.

• Order breakdown: each order should detail the number of units of each product. With this information, the companyshould be able to determine a minimum quantity order to be more efficient and reduce packaging and shipping costs.

• Shipping information: it would be very useful to have information about how the company is managing its shipmentsi.e. whether the company outsources the shipping service to third parties, or whether the company carries out its ownlogistics. With this information, certain decisions could be made in order to become even more efficient in costreduction.

• Industry analysis information: it would be very useful to have information regarding prices and approximate costs (ifpossible) of main competitors. With this very relevant information, the company could evaluate if their target marginsare in line with the industry average. This could allow the company to allocate funds more efficiently to become moreprofitable.

Incentive System

7. Wilkerson has been compensating salespersons with commissions on their gross sales volumes (less returns). Parker wonders whether the company should change this incentive system.


• Understand and quantify the current sales commission model

• Identify problems with the current sales commission model

• Provide an alternative model

CURRENT COMMISSION STATEMENTFrom: March 1, 2000

Name: Wilkerson Sales Killer To: March 31, 2000

Items Sold Units Invoice Amount Commission Rate Amount

Valves 200 $17,200.00

Pumps 200 $17,400.00

Flow Controllers 400 $42,000.00

Total 800 $76,600.00 5.00% $3,830.00

Total Sales $153,200.00

Total Commission Payable $3,830.00

SUGGESTED COMMISSION STATEMENTFrom: marzo 1, 2000

Name: Wilkerson Sales Killer To: marzo 31, 2000

Items Sold Units Invoice Amount Commission Rate Amount

Valves 200 $17,200.00 6.00% $1,032.00

Pumps 200 $17,400.00 7.25% $1,261.50

Flow Controllers 400 $42,000.00 2.00% $840.00

Items Total 800 $76,600.00

Total Sales $153,200.00

Total Commission Payable $3,133.50

Wilkerson currently pays commissions on grosssales. This means that regardless of a product'sgross margin (GM), a sales person is motivatedto sell as many units of the product with thehighest price, as they will be receiving thehighest commission. This is problematicbecause flow controllers yield a negative GMbut its high pricing motivates salespeople tosell these to the company's detriment.

One solution is to pay salespeople on GM. Byweighting each product according to its GM(e.gp pumps have the highest gross margin,therefore, they have the highest commissionrate of 7.25%), salespeople will earn mostwhen they sell more of the most profitableproducts. We suggest weighting the flowcontroller lowest until management canincrease its margins. For now, direct salesefforts to valves and especially pumps whereWilkerson need to maintain their edge againstindustry competitors.

References

• Artill, P & McLaney, E (2006) Accounting and Finance for Non-Specialists. 5th Edition. FT Prentice Hall: Great Britain

• Collier, P (2006) Accounting for Mangers: Interpreting Accounting Information for Decision-making. 2nd Edition. John Wiley & Sons: United Kingdom

• Gowthorpe, C (2003) Business Accounting & Finance for non-specialists. 1st Edition. Thompson: United Kingdom

• Recruiter. (2014). Salary for Sales Representatives, Wholesale and Manufacturing (not including Technical and Scientific Products).Available: https://www.recruiter.com/salaries/sales-representatives-wholesale-and-manufacturing-except-technical-and-scientific-products-salary/. [Last accessed 1 Dec 2014]

Bibliography

• Artill, P & McLaney, E (2006) Financial Accounting for Non-specialists. 3rd Edition. FT Prentice Hall: Great Britain

• Walker, J (2001) Accounting in a Nutshell. 2nd Edition. Elsevier: Oxford