In the Wilkerson Company case study of Harvard Business School, the main issue that the company is facing lower pre-tax operating margin (3%) comparing to historical pre-tax operating margin of 10%. Currently, the company uses simple Overhead Absorption Rate (OAR) in its accounting system. After OAR is obtained through dividing the total manufacturing overheads by the total activity level; it is then charged to different products’ unit cost based on the respective direct labor hour spent. The OAR obtained in this case study is 300%. Referring to Exhibit 1, with the fact that flow controllers have better selling price since this product line is protected from market competiveness, it appears to have the highest actual gross margin of 41.0%; followed by valves (34.9%) and pumps (19.5%). The OAR reflects the company’s major product line – pumps, to hold direct responsibility on the overall poor income performance, mainly due to its continuous price reduction to compete against the market. Conversely comparing the operating statistics in March 2000, the flow controllers recorded the least units produced and yet required the highest production runs, shipments and engineering works. This product line also being charged at low manufacturing overheads comparing to pumps, by reason of its low direct labor cost.
Considering another accounting system, Activity-Based Costing (ABC) identifies the company’s activities level and allocate respective costs based on workload and expenditure; assigning indirect costs to the products’ direct costs. Thus based on the company’s study on Wilkerson’s overheads, ABC would be fair as the selected accounting system to identify the products actual costs, where the manufacturing overheads and other expenses are charged based on the relevant activities level showed in Table 1. Referring to Exhibit 2, the ABC has indicated that valves (46.3%) have the highest actual gross margin, followed by pumps (33.1%) and flow controllers (-9.9%). In fact, it is found that the flow controllers are having negative gross margin due to the extensive workload required to produce and deliver the products. The results for both systems have turned out to be totally different, whereby the flow controllers’ product line in underperforming and should be increased in selling price. As for valves and pumps, the ABC actually proves that valves have achieved, while pumps almost achieve the targeted 35% gross margin.
Recently, Wilkerson Company has raised the price for flow controllers for more than 10%, and it is found that the decision does not affect the sales. Referring to Exhibit 3, raising the price for exactly 10% (approximately $116 per unit) will allow the product’s gross margin to break even with its unit cost according to ABC. Therefore in order to obtain profit, the company needs to raise at least 10% in the selling price. However by taking account of the general, selling and admin expenses, again this product line has suffered great loss in pre-tax operating income. Referring to Exhibit 4, in order to resolve this problem effectively by breaking even the pre-tax operating income for flow controllers, the selling price has to be raised for 108% (approximately $218 per unit). Nevertheless, raising the price for 108% over a short period is an unreasonable yet risky approach; and will definitely affect the sales of the product as clients will look for alternative suppliers in the market. Moreover, Wilkerson could not terminate this product line because of its loss making, mainly to preserve its market reputation and branding as a leading company which provides wide range of products.
Since raising selling price for 108% would not be possible as a short term solution, the price will remained as $116 per unit for the next analysis. Looking on flow controllers required high manufacturing overheads, Wilkerson should put effort in reducing these overheads. By reducing 15% on its machine hours, production runs, number of shipments and hours of engineering work without affecting the production, this will help to reduce the unit cost to drop to approximately $103 and raise the gross margin to 11.3%. Machine hours, production runs and engineering works can be reduced whereby higher efficiency of production planning and processes must be established, together with better coordination and less time spent to carry out these operations. As for shipments, the company should coordinate with the clients where more units or products are being shipped in a single shipment, instead of more shipments with fewer units. Thus, this approach will automatically reduce the costs on receiving and production control, packaging and shipping; as well as general, selling and admin expenses. Referring to Exhibit 5, unfortunately the pre-tax operating income for flow controllers is still showing negative impact.
While Wilkerson still insists to remain the flow controllers’ product line, the next adjustment the company should make would be cutting the production of the loss making products. Referring to Exhibit 6, assuming the company decided to cut down the production of flow controllers by 50%, all manufacturing overheads and general, selling and admin expenses will sensibly reduced by half. This also helps to reduce the pre-tax operating loss of flow controllers by 50% allowing the company’s overall pre-tax operating income be increased to 18%. Nonetheless, cutting 50% of production would not be an easy task as the company has bowed to meet every client’s demand.
Exhibit 7 shows the summary of the results from different accounting systems and approaches applied in order to improve the company’s processes and outcomes. Using ABC, Wilkerson can technically identify the profitability of each product according to their activity levels. Observing the analysis, the overall pre-tax operating income drop to less than 3% was mainly caused by the significant low selling price of flow controllers rather than the price reduction of pumps.
Taking account the level of activities involved in producing flow controllers has made the unit cost outstandingly higher than the others. On the other hand, the company did not notice such issue when using OAR accounting system and therefore setting unreasonably low selling price for these products. Competitors could not compete against the low price and consequently overlooked the profit opportunities in flow controllers; mainly because this product line not just making loss, it also involves substantial investment in the manufacturing overheads and other expenses.
In short term basis, Wilkerson can improve its overall pre-tax operating income from 3% to 18% margin by increasing the selling price, reducing the manufacturing costs and production of flow controllers.
Cost cutting in manufacturing overheads can be achieved by increasing efficiency in operations, technology, production and coordination. As the manufacturing manager, Scotts had designed an automated machine for producing valves whereby this technology consumes lower machine hours, production runs and engineering works; as compare to pumps which have identical manufacturing process. In order to reduce the total manufacturing overheads of Wilkerson, Scotts should apply the similar automated machine concept for other product lines especially flow controllers which involve high production runs and engineering works. Another way to reduce the production runs would be extending the machine hours in a single run, where same number of machine hours to be accomplished in fewer production runs and therefore reduces the setup labor.
To reduce the number of shipments for flow controllers, Wilkerson should negotiate new customer shipping requirements with its clients where larger lots will be shipped on each shipment. Negotiating for preferred shipping requirements and delivery schedule would be a crucial step to the company as both production runs and number of shipments will be directly affected. Setting the proper delivery schedule will best benefit the company by saving large amount of expenses on delivery costs. An example on this approach would be advising the clients to loosen up the “just-in-time” criteria, where in return Wilkerson could offer lower price for the products.
Price increment and production cut would be a great challenge to the company. Raising price would cause clients to seek for other suppliers; while cutting production will cause the company unable to meet clients’ demand. Hence, Wilkerson could take the approach of raising selling price, forcing clients to hold back and seek for alternatives, where this will lead to reduce demands. However, this approach needs to be carried out with cautious so that Wilkerson would not lose out all clients at once; whereby achieving the balance between selling price and unit production is crucial.
As for long term plan, knowing the lack of market competitiveness for flow controllers, Wilkerson should take advantage as the single source or limited market provider. The company can dominate the market through increasing the selling price gradually over the years, with the objective to transform from loss making to maximizing profit. Raising 20% per year in selling price would be reasonable, as the company requires less than 5 years to observe the product profitability.
Besides focusing on the issue of low selling price in flow controllers, Wilkerson should improves other aspects of the business in order to bring the company forward. As pumps being the company’s main products along with Wilkerson being the major pumps supplier, the company should further reduce the selling price in order to capture more market share since the product line currently having a gross margin of 33.1%. By giving up the targeted gross margin of 35%, sales and production for pumps are increased along with additional market share, hence contributing to company’s overall pre-tax margin as well as cover up the loss made by flow controllers.
Giving the fact that valves have unique design which proven better than others in the industry, this innovative idea or approach should be done the same for pumps and flow controllers. By having self-uniqueness, this enables each product to attract more specific clients with special interest and needs, yet product prices are protected from the market competition.
Also based on the historical data last year, Wilkerson has experienced full capacity operation with 12,000 machine hours, 180 production runs and 400 shipments. With the assumption that these capacities were proportionally allocated to each products based on the monthly production and operating statistics obtained in March 2000, the company remains to achieve a pre-tax operating income of 3% margin even though in full capacity production. From here, it is noticed that no matter how well is the company’s sales performance, the profit margin will still remained. In order to change this result, Wilkerson should distribute the company’s capacity efficiently by allocating more capacity to the most profitable products, which are valves followed by pumps. Flow controllers production should be reduced as this product line is suffering a loss and keeping this line of production is merely to maintain clients’ relationship and company’s reputation. With profits from valves and pumps occupying the bigger portion of the company’s pre-tax operating income, the pre-tax margin will be raised significantly.
In conclusion, Wilkerson should use ABC system to indentify its products’ profitability and main factor which causes the company to have an unsatisfactory pre-tax margin. From there, the company should come out with proper solution whilst carrying out these approaches correctly so that these do not worsen the company performance. Besides the high manufacturing overheads, another main cause that the company should be aware of would be the large expenses in the general, selling and admin. Wilkerson definitely needs to optimize its operations and production in order to cut costs spent on these expenses.
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