1. If Wilkerson were to cut prices, based on contribution margin, to just cover short-term variable costs, what consequences could it experience? (5 marks) Several break-even-point assumptions are made in calculation: 1) Total fixed costs do not change with volume, and will exist regardless if the products are sold or not. 2) Sales mix will be constant.
The contribution-margin percentage is 66.1%, which means 66.1 percent of each sales dollar is available for covering fixed costs and making income: $1,365,650/66.1%=$2,065,387 sales are needed to break even.
Based on the existing sales mix and production units given (Valves 7,500, Pumps 12,500 and Flow Controllers 4,000), the break-even prices in dollars (BEP$) are shown as below:
Therefore, based on the data above, if the company cut its prices to just cover short-term variable costs, the company’s total sales would fall by 4.05%, from $2,152,500 to $2,065,387, which would also result in 4.05% drop in the selling price of each unit of products, total variable costs at $699,737, and zero operating income before tax.
2. (a) How does Wilkerson’s existing cost system operate? (5 marks) Wilkerson’s current cost system is based on a simple cost accounting system. Material cost is recorded as prices paid to the suppliers for components. Labour rates and fringe benefits were appropriated to products by using the standard run times for each of their three products at a rate of $25 per hour.
Finally, the company allocated the overhead costs for its sole producing department to products as a percentage (300%) of production-run direct labour cost. However, due to the growth of the company, the 300% estimate may lead to inaccuracies in future projections. Potential problems of the existing cost system are listed as below: 1) It failed to reflect the specialized costs of multiple products 2) It is inaccurate when estimating manufacturing overhead only based on direct labor cost 3) It roughly applied all overhead costs including unused or idle capacity costs to products
2. (b) Develop a diagram to show how costs flow from factory expense accounts to products. (5 marks)
Expense AccountsAccount Contents
3. (a) Develop an activity-based costing model based on actual production volumes. Show full calculations, including gross margin per unit. (8 marks) As below:
3. (b) Develop an activity-based costing model based on capacity. Show full calculations including gross margin per unit. (8 marks) As below:
3. (c) Which cost driver rates should be used? Actual, or capacity? Why? (7 marks)
Activity Based Costing models based on actual production volumes and capacity both provide significant data and advantages over each other. When combined, we are able to observe the costs/losses of our unused capacity. However, if we had to choose one method, based on the above data, we believe that the capacity driver rates should be used for Wilkerson Company. These (actual) figures indicate that we are losing money on our flow controllers, which are consuming a disproportionate amount of the resources – it actually consumes the highest amount of setup, receiving & production control, engineering, and packaging & shipping resources. By using our capacity numbers, we find that if we were to increase our production proportions to utilize our unused capacity and operate at full capacity, we could actually make money on this product line (despite it consuming the majority of our resources).
In addition, our capacity numbers also give us significant data on our product line and our production capabilities, which allows us to make decisions on optimizing our production processes. For example, we look into our packaging and shipping costs for flow controllers to see if we could bundle deliveries to customers ordering additional products, or maybe even see if we are using 20 different vendors, instead of a preferred list (and thereby losing out on a potential discounted rate).
Our capacity figures also demonstrate that we could decide to manufacture the most similar products after each other, or perhaps cut out flow controllers altogether and use those resources to produce valves, which are our highest margin generator, consuming the least amount of our variable costs. Lastly, our capacity figures demonstrate that we are losing money by not producing at optimal levels – this is a magnificent opportunity for improvement.
3. (d) What does the ABC analysis reveal? Why have the cost shifts occurred? (6 marks) Exhibit #1. Product Profitability Analysis Based On Current Costing System
The ABC analysis reveals that it is not Wilkerson’s pumps that are the least profitable (as indicated in their current costing system), but that it is actually the flow controllers that are the least profitable product (due to the lowest volume, and highest receiving & production control, setup, engineering, and packaging and shipping costs). The ABC analysis also reveals that despite Wilkerson’s recent 10% increase in the price of flow controllers that didn’t result in a loss of business, could probably stand to be increased further as it is still priced below costs.
This has showed that our operating income (pre-tax) will not be $57,600. The cost shifts have occurred, because under the current system, Wilkerson has used a single allocation base for all of the overhead – the cost driver was the production unit; whereas ABC uses different cost drivers for the different activities involved in production.
Although pumps have the greatest production quantity, the standard unit cost of pumps is the highest, leading to the lowest gross margin percent of this product. Meanwhile, flow controllers are the most profitable product, with a 41% actual gross margin, ranking the top among the three products of Wilkerson.
Exhibit #2. Product Profitability Analysis Based on ABC
After examining the production costs through ABC, we found that flow controllers are actually the least profitable product of the company. Specifically, under ABC accounting, flow controllers (which have the least production volume), consume the most receiving & production control, engineering, and packaging & shipping resources. This means the actual per unit production cost of flow controllers is $83.38, not $30, as previously thought (making flow controller unprofitable). On the contrary, pumps appear to be profitable under ABC.
Theoretically, the reason why the cost has shifted is due to the difference between ABC and traditional costing. Under a traditional costing system, a single allocation based can be used for all overheads. In this case, Wilkerson simply allocated the overhead costs to products according to 300% of production – run direct labor cost. Based on this, the manufacturing overhead per unit of pumps was $12.5 × 300% = $37.5, while that of the flow controllers was $10 × 300% = $30.
However, under the ABC model, there are different cost drivers due to different relationships between overheads and production activities, and overhead costs are allocated based on resources consumed; which means a more accurate allocation of overheads is available. In detail, the manufacturing overhead per unit of pumps is $25.70, when that of flow controllers $83.38 – almost triple the number under traditional costing.
In the actual production process, this shift of costs is because flow controllers require more components and more labor. Moreover, due to various types/models, more production runs and shipments are also needed when producing flow controllers. These requirements will increase the manufacturing overhead of this product inevitably. As we have seen, the production of flow controller consumes the most resources of three – fourths of the cost driver activities. This explains the transfer of the overhead costs.
4. What recommendations would you make to management based on your findings? (16 marks) We would suggest that Wilkerson abandon the current traditional costing system in favor of an ABC system instead. We believe that management should investigate their costs of unused capacity, since it is currently a source of lost income for them. Management should recognize that their flow controller product line is currently costing them money and eating into their gross margins, which could be improved if capacity production rates were raised based on their current proportions. Although a recent price increase has not resulted in any lost business in this line, we believe that either an additional increase in price or other measure is required to make this a more lucrative product line. This inelasticity in price makes us think that there may be a greater margin out there, since they seem to be pricing themselves below cost.
Secondly, we believe that management could investigate a possible change in product offerings. We have seen that the flow controller line is consuming a great deal of resources, and we feel that there may be multiple optimization possibilities that are being missed under their current production model. Wilkerson appears to make strong margins on valves while using fewer resources, and we believe that this is a good place to start to analyze an opportunity like this. The price of pumps has declined, which should draw their attention as cause for concern in their costing or pricing methods. In addition, we believe that offering three products may result in Wilkerson incurring unnecessary setup times which are contributing to an unnecessary consumption in resources for small production runs.
If Wilkerson was in a position to negotiate with its customers, it might find that it is able to enforce minimum order sizes, or perhaps even stretch out the time period for getting the product to its customers. For example, if customers place orders daily, Wilkerson might be able to “pool” those orders and do production runs once or twice each week instead of more frequently. This could be an opportunity for cost savings for setup, production, and packaging/shipping costs, while being within perfectly acceptable delivery/service standards to clients by delivering products every (for example) 72 hours rather than within 24 hours of order placement, etc. Another possibility would be to electronically link a just-in-time sales trigger with their customers, that monitors product levels and automatically requests refreshed inventory.
We also see that Wilkerson uses “the same equipment and labour for all three product lines”, which strikes us as an opportunity for either further optimization, or perhaps even an opportunity to redesign certain components to obtain a higher degree of standardization (especially for flow controllers, which has “… much more variety in the types … used in the industry, so many more production runs and shipments were performed for this product line than for valves”. This may result in such things as decreased production costs or decreased production time, both of which could facilitate a higher level of production volume and greater profits for their business. Further analysis is required. Lastly, we may find that Wilkerson could use some of their unused capacity to create a minor inventory to cover issues such as raw material shortage, labour shortage, or machine malfunction, all of which adds to downtime and potential lost income. By having a small inventory, machine setup costs could be reduced for the small batches that are being ordered by customers (i.e. flow controllers).
5. What are the limitations of the ABC analysis? (10 marks) One of the limitations of Activity Based Costing analysis is that it can consume a great deal of resources (time and labour for implementation and maintenance) to compile the data necessary for analysis and record keeping for historical purposes/trend analysis. Being a tool for management accounting (and used for internal purposes), this will involve an additional set of records and analysis above and beyond the normal set of books done for financial reporting (external users). ABC is not ideal for all situations, as it offers beneficial results only under specific conditions: “(1) that total costs can be partitioned into cost pools, each of which depends solely upon one activity; (2) each cost pool must be strictly proportional to the level of activity in that cost pool … so costs that are not strictly variable at the level of the cost pool should be excluded from the allocations…; and, (3) each activity must be able to be partitioned into elements that depend solely upon each product – this can cause problems with joint processes.”
2 Another limitation of the ABC analysis, is that it has left Wilkerson in a position where they have not taken into account their General, Selling, & Admin Expense ($559,650), which is almost equal to 70% of their MOH costs. This is a huge amount of money that doesn’t show up in ABC, and has an enormous impact on the perceived profitability of the company. For example we cannot use it to divide some the salaries of the marketing team or CEO who have done casual business development, etc. ABC could also be a cause for confusion and disagreement among employees, as there are a number of activity pool costs to look at. For example, there are machining hours, maintenance hours, labour hours, etc. – it might become a source of disagreement or confusion as to which is the appropriate activity cost pool to use for analysis. This could also lead to measurement errors as costs get attributed to the wrong cost pool, such as when an engineering employee performs setup duties to help an understaffed production team – are these hours really engineering hours, or setup hours, or labour hours?