1. Wilkerson company ‘s major productions are pumps, valves and flow controllers. Pumps: The competitors had been reducing prices on pumps. Since pumps were a commodity product, the company matches the reduced prices to maintain volume. However, it has dropped pre-tax margin to less than 3%. Valves: Although several competitors could match its quality, none had tried to gain market share by cutting price, the gross margin had been maintain at standard 35%. Flow controllers: There was much more variety in the types of flow controller used in industry, so may more production runs and shipments were performed for this product line. However, Wilkerson had recently raised flow controller prices by more than 10% with no apparent effect on demand. Overall: The Company’s profit decline and face price competition for pumps and overhead costs has become much larger than the direct labor expense.
2. No, the executives should not abandon overhead assignment to individual products entirely. Because the assigning overhead cost to each product line is reasonable to reflect the cost of each product. Setting prices base on product-line contribution margins is not very accurate. Because it could underestimate the cost without including overhead cost and thus it could set lower price and with lower profits.
3. Wilkerson currently uses a simple cost accounting system. Each unit of product was charged for direct material and labor cost. The cost drivers for direct material cost and direct materials are reasonable and feasible. However, the overhead costs were allocated to products as percentage of production-run direct labor cost, it could not accurately reflect the actual overhead cost for each product line. For example, valves’ machined components could be machined automatically, it require less labors. In addition, the machine-related expense might relate more to the machine hours of a product than to its production-run labor hours.
4. The difference between the activity- based model and the simply cost accounting system is that the activity-based model allocated the overhead cost to each product line based on the individual activities. However, the original cost model allocated its overhead cost by simply 300% of direct labor cost of each product.
Based on the activity-based model, it shows that the product line of Valve is the most profitable with 46.32% gross margin rather than 34.9%. However, the product line of flow controllers generated -9.88% gross margins. It is much lower than 41% that was generated by original cost model. The reason caused shifts in cost and profitability is that the flow controllers required more components and more labor, than pumps or valves, for each finished unit. In addition, many more production runs and shipments were performed for this product line than for valves. Thus, the overhead cost was shifted from valves to flow controller and the profitability of each production line was changed.
5. Based on the analysis of question 4, Wilkerson’ management team could consider following actions to improve the company’s profitability: 1) For valves and pumps, the company could reduce price in order to gain market share. If based on the activity based costing, the valves and pump has 46% and 33% gross margins respectively, that means there are enough space for price reducing and still be profitable. 2) For flow controller, as mention in this case, the company could increase price more than 10%, since there is no apparent effect on demand for past price raising. On the other hand, the company could improve its productivity for this product line and try to reduce manufacturing cost. in addition, the company also could purchase semi-finished component from outside, if the purchasing price is cheaper than producing.
6. There are some concerns when using activity based costing model. It is costly to implement and maintain. on the other hand, the allocation for each item need to be accurate and reasonable, otherwise it could cause misleading for operating management. Firstly, in order to trace every item, it needs to design an accounting information system to gather each type of cost and activity. Secondly, it is necessary to gather and report activity and cost driver information frequently. Thirdly, employee needs to be trained to use the ABC system effectively.