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Wilkerson Company

Activity Based Costing

Professor Doug Cerf


Donald Bren Graduate School of Environmental Science
and Management
Corporate Environmental Management (ESM 281)
Spring 2008
Purpose of Wilkerson Case

• System of appropriate allocation of


overhead costs to products for proper
product profitability determination
• Decisions:
– Product pricing
– Product introduction
– Production retention/elimination

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Activity Based Costing

• A method of allocating support (overhead) costs to


products or services based on drivers of those
costs
• Activity-based costing was first clearly defined in
1987 by Robert Kaplan and William Burns as a
chapter in their book Accounting and
Management: A Field Study Perspective
(Harvard Business School Press 1987)
• Kaplan is author of this case

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Applicability to Bren students

• Allocation of environmental costs from


overhead
– If allocation of environmental costs are not
properly assigned to products, the products that
do not cause environmental damage are
subsidizing the products that cause the damage

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Environmental Examples

• Were the cost of products produced during


the creation of the superfund sites
understated?
– If so, then the profit was overstated.
– This leads to production of unprofitable products.
• Is it inappropriate to include the cost of
cleanup related to past damage in the cost
of current products?

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Costs to consider in pricing a
product
• Current environmental costs
• Costs related to cleanup of environmental damage from
past operations
• Costs related to cleanup of environmental damage from
current operations
– Companies may become responsible in the future for operations that meet
current minimum environmental standards, but do not meet requirements
of future regulation
• If you price products based on competition then how will
knowing the “true” cost help?
– The “true” cost will help a firm make appropriate product
retention/elimination decisions

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Activity Based Costing System

• Conditions under which ABC system is beneficial


– Large and growing indirect and support costs
– Diversity among products overhead needs
• Example:
– Company produces two types of paint, one that
generates hazardous waste and one that does not
• Issue: Cost of hazardous waste disposal is part of overhead
and overhead is allocated base on direct labor hours

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Questions
1. What is the competitive situation faced by
Wilkerson?
2. Given some of the apparent problems with
Wilkerson’s cost system, should executives
abandon overhead allocation to products entirely
by adopting a contribution margin approach in
which manufacturing overhead is treated as a
period expense? Contribution margin is price
less direct costs (labor, materials). Why or why
not?

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Questions
3. How does Wilkerson’s existing cost system operate?
Develop a diagram to show how costs flow from factory
expense accounts to products.
4. Develop and diagram an activity based costing model
using the information in the case. Provide your best
estimates about the cost and profitability of Wilkerson’s
three product lines. What difference does your cost
assignment have on reported product costs and
profitability? What causes shifts in cost and profitability?
5. Based on your analysis for Question #4, what actions
might Wilkerson’s management team consider to improve
the company’s profitability?

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Questions

6. What concerns, if any, do you have with the cost


estimates you prepared in the answer to Question
#4? What other information or analysis would
you want for better cost and profitability
estimates?
7. Wilkerson has been compensating salespersons
with commissions on their gross sales volumes
(less returns). Parker wonders whether the
company should change the incentive system.

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