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Wilkerson Company Case Study

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    Additional Aspects Of Product Costing Systems

    Changes from Tenth Edition Chapter 18 was modified to include discussions of customer-related and business-related cost drivers and recent evidence about the usage and success of activity-based cost systems. Approach Our treatment of job costing and process costing is as brief as we can make it and still get the general points across. Students do need to understand the general idea of these cost accumulation procedures; otherwise they are unable to visualize how costs are actually collected. The details, however, are appropriately left for an advanced course.

    The principal pedagogical problem here is how to get across the idea of equivalent production in process costing. Some introductory texts omit this idea, but this strikes us as dangerous because some student is almost sure to ask what happens in a process cost system if not all the units are completed by the end of the period. If the answer is not in the text, the instructor either has to duck the question, or attempt the difficult task of explaining it on the spot. In the text and in most problems, we assume that units are 50 percent completed as to labor and overhead.

    Since this assumption is widely used in practice, we see no point in complicating the text by introducing other percentages. Certainly, the most difficult part of this chapter is the section on development of overhead rates. In our experience, mastery of this material greatly reduces the omnipresent problems students have later with production overhead variances. We also find in this regard that students need to be referred back to the text section, “Why Overhead Rates Are Predetermined,” especially in later discussions of the overhead volume variance.

    We have placed emphasis on the flexible overhead budget to help minimize these learning difficulties. We feel that the new section on ABC provides the appropriate level of depth for a required course. Students need to understand the potential benefits of ABC as well as that it are not a panacea. It is important for students to realize that ABC is a decision-support model rather than a transaction processing system. Cases Wilkerson Company is a simple activity-based costing case.

    It requires students to calculate the costs of three products using on a new set of cost drivers, to compare those costs with those calculated using traditional direct labor-based allocation bases, and then to understand what the numbers mean. (This is a new case with the Eleventh Edition. ) Huron Automotive Company gives practice in computing and using costing rates and shows the differences that result from different definitions of cost centers. It also has two optional questions involving differential analysis, for the instructor who wishes to keep emphasizing that full costs are not used for all cost-related management decisions.

    Siemens Electric Motor Works (A) effectively helps students discover the key concepts and potential benefits of ABC. (If an additional case is desired, we suggest the John Deere case cited in footnote 17. ) Dakota Office Products requires students to understand the mechanics of customer profitability analysis and then to use the information for strategic decision making purposes.

    In this case, where the same type of product is packed each month, the most valid overhead rate to use is probably the annual rate of $13. 00 per hour. A case of a given product whether packed in the slack season or the busy season should bear the same share of indirect cost, assuming the same production techniques, raw materials, and labor usage.

    Problem 18-5 Journey’s End, Inc. This is a pretty standard, but simplified, activity-based costing situation. The main twist is that distribution channels, rather than products or customers, is the cost object. Students must do the Stage I allocations (trace the costs to activities), compute the proper Stage II cost driver percentages (showing the channels’ consumption of the activities), to apply those percentages in allocating the activity costs to the channels.

    1. Tracing the costs to activities.
    2.  Channels’ consumption of the activities.
    3. Allocating the activity costs to channels.

    One error that some students might make is to allocate the “other” costs to channels, by assuming a cost driver. No reasonable basis for a cost driver assumption is provided in the case.

    Allocating these costs could swamp the meaningful allocations that could be made.

    Here are some of the questions raised:

    • Should the company should continue to use the channel now revealed to be a loser (corporate)?
    • Are there some cross selling possibilities or sticky or unavoidable costs that make it undesirable to exit the corporate business?
    • Should/can prices be raised in certain areas?
    • Can some of the costs (e. g. , those related to the costly negotiation process, commissions) be reduced?
    • Should a minimum order size be instituted in the corporate business?
    • Should the company’s cost system be altered to consider SG&A costs on a regular basis?

    Wilkerson Company Purpose of Case

    This case provides a description of a simple activity-based cost (ABC) system. Within a minimum of complexity, it illustrates the ABC principles and the effects that use of such a system can have.

    Teaching Plan

    Start with student giving competitive situation faced by Wilkerson: Mature products, declining profits. The price environment is confusing. There are high margins and little price competition in one line (flow controllers), and continued price pressure in another (pumps).

    What is the structure of the existing cost system? Direct labor $271,250 Direct material $458,000 Overhead $806,000 Products ? (300% of DL$)

    What are the features of this system? High overhead costs ($806,000) being applied using DLS$ ($271,250), leading to high burden rate: 300% Single production cost center Some processes use automated machines; different ratios of machine hours to DLH; probably better to have costs driven by machine hours in automated processes Simple, easy to implement since already measuring DL$ at the individual product level Fails to capture product diversity & complexity: valves and pumps have only 4-5 components; flow controllers have 10 components. Each component requires purchasing, receiving, setup and machining activity.

    Should Wilkerson abandon its overhead cost allocation system and make managerial decision based on contribution margin (price less variable costs); in effect use marginal costs rather than average costs? Not easy to know which elements of overhead are variable. Contribution margin OK for short-term decisions, such as whether to accept a one-time order when operating with excess capacity.

    With only three main product lines, and overhead ($806,000) well in excess of DL and DM costs, CM does not reveal the different demands that individual products make on overhead resources (for machine time, engineering design, setups, receiving, shipping, etc. ). Want to understand the impact of variety in use of OH resources by individual products. If cut prices based on contribution margin to get new business, should be cautious about: (i. ) competitive reactions, (ii. ) having to lower prices to existing customers, (iii. filling up capacity with business that doesn’t pay for capacity costs. If cutting prices, when near capacity, demand could increase beyond existing capacity. You end up having to supply more capacity for support resources to handle the work, and not being paid for supplying these capacity resources.

    Could also note that we have: Transaction drivers: shipments, production runs (setups) assumes same cost/incident. Duration driver:machine hours, engineering hours assumes same cost per hour of use (no difference in capital intensity or quality/pay of engineers).

    If this assumption is invalid, then use intensity driver – actual cost of resources used or create more activity centers to reflect differential pricing. Optional:Before doing any calculations, which products will be most affected by using the ABC system? Cost of valves will decrease – high volume product benefits from lower unit-level costs, long runs, little engineering support Cost of flow controllers will increase – had less unit level activity (DLH, Mhrs) and more transactional (production runs, shipments) and product support (engineering hours) activity . Which cost driver rates should we use: actual or capacity-based? Doesn’t make a huge difference here because working near capacity Recall Anagene; when a plant is well below capacity, the cost driver rate is high; could lead to under-utilization of the resource (engineers will spec their products to run on resources with lower rates – thereby increasing the demand on bottleneck resources; and avoid using resources with high rates – thereby further under-utilizing a resource with lots of surplus capacity.

    Attempts to recover the high resource cost in pricing will likely lead to lower demand, less utilization of the resource, and a potential death spiral. Conceptually, preferable to use capacity costing (or the capacity utilization anticipated when the resource (machine) was acquired). Resource costs not assigned to actual production will be featured in an unused capacity category.

    What are the revised product costs?  Valves are actually highly profitable; pumps are about normal profitability – probably the right decision to match competitors’ prices; flow controllers are just breaking even–now we understand why competitors are not undercutting our recent price increases.

    Why have the cost shifts occurred? Valves are high-volume, have low support costs per unit: Flow controllers are “overhead-intensive;” consume lots of overhead resources per unit produced. What actions are suggested by the traditional cost system? Lower material costs: Choose cheapest suppliers and components (look for discounts for high volume purchases, perhaps compromise on quality, search for overseas suppliers. Design products with lots of components, many unique, if this leads to lower material costs.

    Don’t worry about using common components across different product lines (no apparent benefit) so enormous component proliferation: in 1985 Hewlett Packard and Tektronix used upwards of 150K different components in their various products. Each time a new instrument was designed, engineers started with a clean slate – no motivation or incentive to use components already being ordered and stored in large quantities for existing products. Enormous proliferation of vendors – keep shopping for lowest price from any vendors – leads to large “vendor-sustaining costs. ”

    Lower labor costs: Spend lots of IE resources to reduce standard DL times (save DL$ + 300%); Automate; shift production overseas to low labor cost countries. Leads to highly efficient production machines (based on run time) but which could be very inflexible – long changeover times.

    What actions are suggested by the ABC system? Managers still get benefits from lowering material, labor and machine time costs; but they also see big opportunities from:

    Operational improvements to perform batch and product sustaining activities more efficiently (with fewer resources): e. . , decrease setup times, lower cost of receiving and materials handling, cost of packaging and shipping, and the engineering support required for flow controllers

    Redesigning flow controllers to use fewer components; to reduce demand for receiving, setup, and engineering activities. Try to share components already being used by high-volume valves and pumps. Examples of problems in this area:

    Campbell Soup – 17 different specifications for diced carrots in its soups.

    Chrysler – how many different wire harnesses should they have?

    Eaton thought 6, cost accountants said 12. ABC said 6 based on production costs. But counting distribution and dealer inventory costs – best number was 2.

    Try to achieve uniqueness at final stage of assembly (Dell Computer – many, many final combinations from a very limited range of ICs, monitors, hard drives, RAM, printers, … ) rather than assembling unique products from uniquely-fabricated components. “Strategic actions” to reduce the quantity of activities Wilkerson has to perform: Pricing – be more aggressive on pricing flow controllers; continue to meet competition for pumps since profit margins still reasonable; valves – no reason to start discounting the price if customers are not complaining or defecting, but watch for competitors undercutting our prices to steal customers. If fewer orders (from higher prices), then fewer activities to perform.

    Minimum order size – particularly with flow controllers to reduce the high overhead cost per unit associated with small production runs and small shipments

    Hope that someone brings up questions about how the above actions lead to lower expenses for Wilkerson. If reduce demands for OH resources through combination of strategic actions and operational improvements, will create unused capacity. Must act to exploit this unused capacity either by increasing the volume the company produces and sells or by eliminating resources (capacity) no longer needed. Can retain “unprofitable” or low margin products – since many indirect and support resources are not easily reduced in the short run.

    But then the CFO must insist that no capacity-expanding investments will be made until all unprofitable products are removed from current resources. Cheapest source of new capacity is that freed up from stopping the production of products that are not paying for the existing capacity.

    What are the limitations of the analysis? (a) Measurement issues: ABC analysis is expensive, requires more data collection for a small company, with limited staff and information resources. Estimates are more subjective and have higher measurement error– especially on engineering effort. Could the measures be biased by management judgments?

    Also, the cost drivers (except for engineering and machine hours) are all transactional – assume that each setup, each production run, each receipt, each shipment requires the same resources. These activities could have different durations (or intensities) for the different products – will need to investigate and test the homogeneity assumption that allows us to summarize activities with simple transaction drivers. (b) The analysis ignores the substantial GS&A expenses, which at $559,650 are larger than any single overhead category (as well as direct labor or materials expenses).

    Wilkerson should analyze the GS&A expenses, try to drive these to product lines or customers not just product profitability. This opens up the opportunity for targeted actions for individual customers. (c) Management issues: defensive reactions to revelation of unprofitable products or customers; inefficient processes (excess capacity); poorly-designed products. Managers will not say they feel threatened or embarrassed. Rather they will criticize the ABC model – simplistic (or too complex), doesn’t capture well the “real world. ” Analysts don’t understand the complexity of the business.

    Analysts/consultants must be willing to be vulnerable but not weak. Offer to work with the critic to improve the model to the point where he/she is satisfied it captures economically reality sufficiently well (add cost centers or new activities, use more accurate cost drivers (duration, intensity), …. But then expect that the manager will take some action to address current drains on company profitability. [See Argyris & Kaplan, Accounting Horizons (Sept. 1994)] 13. If time is available, you can ask about any changes in compensating salespersons.

    With the ABC information, you can move from commissions on sales volume to net operating margins (see Exhibit TN-3). Allow salespeople to sell unprofitable products – but these will not be commissionable, or commissions can be based on net margins generated by salesperson, across all products and customers sold. Allow salespeople to discount when they feel it necessary, and accept small orders for non-standard products.

    Wilkerson Company Case Study. (2017, Feb 04). Retrieved from https://graduateway.com/wilkerson-company-case-study/

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