There are many different types of cost systems a company can choose from when calculating their costs. Two of the most frequently used cost accounting systems are a volume based cost system and an activity based cost (ABC) system. Each system has their own advantages and disadvantages and some are more common among certain industries. Wilkerson, like many other companies, used a simple/volume based cost accounting system. Under this system, Wilkerson was inappropriately allocating their costs by assigning the overhead expenses based on direct labor, thus calculating their total costs and operating income incorrectly.
If Wilkerson continues to operate their company ignoring the fact that their costs are inaccurate, it is possible that they may make poor business and pricing decisions in the future. Although Wilkerson’s costs are currently being calculated incorrectly, if they decide to use an activity based costing system, they may achieve more accurate results.
Using a simple cost accounting system is often easier and less time consuming than an activity based costing system, but it is also less accurate. Wilkerson’s implementation of an ABC system would most likely be very beneficial to the company in terms of both determining their costs more precisely and making overall better pricing and business decisions. An ABC system at Wilkerson would look very different than their current volume based system. Wilkerson’s ABC system would use machine-related expenses, setup labor cost, receiving and production control, engineering, and packaging and shipment as the cost pools.
The revised per unit product costs under this system would be $46.17/valve, $58.20/pump, and 115.38/flow controller and the margins would be 46.3%, 33.1%, and -9.9%, respectively. The results when calculating product costs are so different depending on the cost system because we are now actually determining the costs per unit with multiple cost pools because each resource uses a different amount of the indirect resources rather than assigning the manufacturing overhead cost solely based on the direct labor costs.
Based on this new accounting information I would recommend that Wilkerson try to make an improvement in their flow controller product. Since the gross margin for this line is negative, if adjustments are made but there is no improvement in its profitability, I would tell Wilkerson to consider dropping the line completely. Although Wilkerson would lose $420,000 in sales, their costs would be reduced by more than this amount, ultimately increasing overall profits for the company. Unfortunately, there are some limitations in our analysis of Wilkerson’s alternative cost systems.
One limitation is that we are unable to easily assess how the market will react to a change in the flow controller line. A second limitation that we have to consider when looking at our analysis is that although our cost allocations are much more accurate than before, these costs are still the averages for each product, which could impact how accurate we are in determining the costs. However, if we are able to look past these limitations, our analysis of Wilkerson is beneficial in shaping how the company can more accurately calculate costs as well as be more profitable in general.