Management Accounting for Multinational Companies Solution to the Wilkerson Case Igor Baranov

Executive Summary Taking into account the difference among product and high proportion of overheads, Wilkerson should abandon its existing cost system and move to activity-based costing. The profitability analysis indicates that the company earns healthy margins on pumps and valves. However, the margin of flow controllers at actual usage of capacity is negative. Wilkerson should consider action targeted at cost reduction (changes in flow controllers design or in their production and delivery process) or raising the price of flow controllers for customers. Since flow controllers are customized, the company can set different prices for different customers (groups of customers) based on the actual amount of resources spent (e.g. implement activity-based pricing). Problem Wilkerson has to estimate the profitability of its products in order to make long-term product mix decisions. These decisions should be based on estimation of product costs and might include decisions to continue / stop production of a particular product, pricing decisions, and decisions concerning product and process design, including customer relations. Information Information about direct labor and material costs as well as overhead costs is available. Overheads are recorded by five cost pools (machining, setup labor, receiving and production control, engineering, and packaging and shipment). We assume that the current month is typical in terms of (a) capacity utilization, and (b) cost of resources. Analysis Competitive situation The competitive situation varies for Wilkerson’s products. Pump and flow controllers are on the opposite sides of the spectrum. Pumps are commodity products, produced in high volumes for a market with severe price competition. Flow controllers, on the contrary, are customized products, sold in a less competitive market with inelastic demand at the current price range. The third product, valves, is standard, produced and shipped in large lots. Wilkerson is a quality leader, but this leadership may soon be contested by several competitors. Although they are able to match Wilkerson’s quality, there are no signs of price competition yet. Nevertheless, in the long-run Wilkerson should be prepared to compete on price. Existing (pumps) and potential (valves) price competition pushes Wilkerson to analyze its overhead costs, since no reserves of cost cutting are left in its supply chain (both customer and suppliers agreed to just-in-time delivery).

setup labor cost. Option I: Direct costing and Contribution analysis Direct costing and contribution analysis are adequate for short-term decision making (e. Products vary in terms of consumption of indirect resources. The next step is choosing most appropriate cost drivers that reflect the relationship between volume of production of individual products and level of overheads. receiving and production control. direct costing would provide highly unreliable information for decision-making when overheads are so significant and there is variability among products. Two factors demonstrate that volume-based costing may produce inadequate estimates of the unit cost:   Overheads are quite high (300% to direct labor cost). activity-based costing allows finding individual relationships between volume of production and different overheads. although they don’t relate to direct labor technologically. Currently overheads are allocated to products in proportion to direct labor costs. however. In the long-run under price competition. and production control activities are changed in proportion to number of production runs. Wilkerson should pool overheads into five groups (cost pools): machine-related expenses. It becomes possible due to combining overheads into cost pools and allocating these cost pools to products in proportion to selected cost drivers that reflect these individual relationships between volume of production and level of overheads. whereas flow controllers are customized. Existing volume-based costing with one-stage indirect cost allocation (from aggregated cost pool to products) doesn’t allow differentiating indirect cost among products in accordance with their demand on indirect resources. so we should expect higher unit cost for the latter. Both setup and receiving. Indirect cost (overhead) is allocated to cost objects (products) in proportion to direct labor cost at the rate of 300%. Direct materials and labor costs are based on standard prices of materials and labor rates. While volume-based costing is implicitly based on an assumption that there’s a direct relationship between volume of production of individual products and level of overhead. Option II: Activity-based costing Activity-based costing allows tracing indirect costs to product with a high degree of accuracy. packaging and shipment.g. Besides.Existing cost system Currently Wilkerson implements volume-based full costing. the company needs to be sure that each product is at a minimum break even. Engineering cost can be allocated in proportion to hours of engineering work. Pumps and valves are standard products. whereas packaging and shipment activity is driven by the number of shipments. engineering. . Machine hours are the most natural cost driver for machine-related expenses. accept or reject an additional order when only those costs that would change if a particular option is taken are relevant).

cost drivers and calculated cost driver rates are presented below: Activity/ Cost pool MachineRelated Expenses $336. their gross margins.500 =$ 1.25 100 * 1.33 10 * 1.500 = $2.000 = $12.66 10 * 500 / 7.000 Production runs 160 $250 / run Receiving and Production Control $180.67 $46.00 100 * 250 / 4.50 $115.200 Cost driver rate $30 / machinehour Per unit cost of products can be found as a sum of direct labor and material costs and allocated overheads. flow controllers generate negative gross margin (under assumption made).5 * 30 = $15.00 0.00 $10.50 250 * 80 / 7.000 Hours of engineering work 1. Table 1 Product unit costs under ABC Cost items / Products Direct costs Direct materials Direct labor Machine-related expenses Setup labor Receiving and production control Engineering Packaging and shipping Total cost Valves $16.3 * 30 = $9.000 = $6.000 = $28.The selected cost pools.500 = $0. Customized product (flow controllers) appeared to be much less attractive for the company that standardized valves and pumps.500 = $1.20 Flow controllers $22. Overheads . Each cost driver rate is multiplied by the volume of cost driver for an individual product and then divided by volume of production of this product (see Table 1).000 = $27.000 Setup Labor $40.500 = $4. Actually.5 * 30 = $15.500 = $2. therefore. while valves and pumps are much more profitable than the company initially believed (see Table 2).125 / 7.50 0.13 625 * 80 / 4.00 50 * 250 / 12.50 375 * 80 / 12.00 $12.00 10 * 250 / 7.17 Pumps $20.125 / 4.00 50 * 1.00 0.38 Activity-based costing provides more accurate information about product cost and.80 $58.500 = $0.00 $10.50 220 * 500 / 4.125 / 12.000 Production runs 160 $1.250 $80 / hour Cost driver Machinehours 11.125 / run Engineering Packaging and Shipment $150.40 70 * 500 / 12.500 = $2.000 Number of shipments 300 $500 / shipment $100.

if temporary. but need to react to negative profitability of flow controllers.00 19. we should acknowledge the fact of having unused capacity in the “typical month” that we consider.20 33.00 34. We assume here. so we are not able to accommodate the impact of variability of volume of product on unit costs.Standard unit costs .5% $62.Actual gross margin (%) $86. their unit costs are average and might vary significantly for a specific configuration (cost of production) or a specific customer (cost of delivery).9% Wilkerson can continue to decrease prices of commodity products (valves and pumps) since their margins are quite high. Higher capacity utilization will increase products’ gross margins. if capacity utilization goes up as stated. If the demand can be higher in some months. So.3% $58. although significant. can be subtracted from the company’s profit along with general and administrative expenses. Preliminary analysis indicates that flow controllers might have low. leaving aside cost of unused capacity. The latter. on decision made on the basis of full cost analysis.38 -9. .Actual gross margin (%) Activity-based costing: . although we know that they are customized.0% $46. therefore. that calculations are done for a representative (typical) month in terms of capacity utilization.Standard unit costs . Regular analysis of product profitability based on activity-based costing is an expensive exercise.00 Pumps $87.17 46. Correction for unused capacity Variations in capacity utilization may have significant impact on unit costs of individual products and. but positive margin.00 $56. and Wilkerson can still meet it. We also assume that costs of resources (including cost driver rates for overheads) are constant for a given time horizon of decisions made on the basis of calculations. cost analysis for individual products should be done on the basis of cost of used capacity only.00 Flow controllers $105. Limitations of analysis Our calculation of cost drivers and product cost doesn’t allow revealing the difference between individual flow controllers.1% $115. If we can reasonable believe that the company can actually increase the level of capacity utilization in the long-run.00 41.9% $70. weren’t allocated among products.Table 2 Product profitability: volume-based costing vs activity-based costing Valves Actual price Volume-based costing: . General and administrative expenses.

and price inelastic demand.Recommendations Taking into account variability among products in demand for indirect resources. high level of overheads and absence of linear relationship between the volume of activity and volume of production of individual products. switch to batch production and delivery to decrease the cost per unit associated with production runs and number of shipments. The company can also consider a set of action that might reduce the cost of flow controllers: change their design. Based on the information about unit cost obtained by ABC we can recommend the company to review its policy in respect to flow controllers. adjust the production process to eliminate waste of resources. Wilkerson can change prices of individual flow controllers in order to secure healthy profit margin. One of the ways of doing this is setting prices in accordance with the amount of resources consumed (activity-based pricing) by individual product or customer. Having in mind the absence of price competition. . customized nature of a product. we recommend to move from traditional volume-based costing to activity-based costing.

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