Assignment subject cost management wilkerson company case study

TRƯỜNG ĐẠI HỌC KINH TẾ QUỐC DÂN VIỆN ĐÀO TẠO TIÊN TIẾN, CHẤT LƯỢNG CAO VÀ POHE  _ _ ASSIGNMENT SUBJECT: COST MANAGEMENT Lecturer: PhD Nguyen Thi Hong Tham Credit class: QTTH1116E(222)_CLC_01 Group members: Nguyen Hong Tham-11216813 Nguyen Thi Nguyet-11216788 Nguyen Thi Hong Ngoc-11219491 Nguyen Thi Quynh Chi-11217669 Dam Thi Minh Huong-11219359 Pham Phuong Hoa-11218606 HA NOI - 2023 Question Personal in charge Nguyễn Hồng Thắm Nguyễn Hồng Thắm Nguyễn Thị Quỳnh Chi Nguyễn Thị Hồng Ngọc Phạm Phương Hoa Đàm Thị Minh Hương Nguyễn Thị Nguyệt Wilkerson Company Case study The decline in our profits has become intolerable The severe cutting in pumps has dropped our pre-tax margin to less than 3%, far below our historical 10% margins Fortunately, our competitors are overlooking the opportunities for profit in flow controllers Our recent 10% price increase in that line has been implemented without losing any business Robert Parker, president of the Wilkerson Company, was discussing operating results in the latest month with Peggy Knight, his controller, and John Scott, his manufacturing manager Their competitors had been reducing prices on pumps, Wilkerson’s major product line Parker had seen no alternative but to match the reduced prices to maintain volume But the price cuts had led to declining company profits, especially in the pump line (summary operating results for the previous month, March 2000, are shown in Exhibits and 2) Wilkerson supplied products to manufacturers of water purification equipment The company had started with a unique design for valves that it could produce to tolerances that were better than any in the industry Parker quickly established a loyal customer base because of the high quality of its manufactured valves He and Scott realized that Wilkerson's existing labor skills and machining equipment could also be used to produce pumps and flow controllers, products that were also purchased by its customers They soon established a major presence in the high-volume pump product line and the more customized flow controller line Wilkerson's production process started with the purchase of semi-finished components from several suppliers It machined these parts to the required tolerances and assembled them in the company's modern manufacturing facility The same equipment and labor were used for all three product lines, and production runs were scheduled to match customer shipping requirements Suppliers and customers had agreed to just-in-time deliveries, and products were packed and shipped as completed Valves were produced by assembling four different machined components Scott had designed machines that held components in fixtures so that they could be machined automatically The valves were standard products and could be produced and shipped in large lots Although Scott felt several competitors could now match Parker's quality in valves, none had tried to gain market share by cutting price, and gross margins had been maintained at a standard 35% The manufacturing process for pumps was practically identical to that for valves Five components were machined and then assembled into the final product The pumps were shipped to industrial product distributors after assembly Recently, it seemed as if each month brought new reports of reduced prices for pumps Wilkerson had matched the lower prices so that it would not give up its place as a major pump supplier Gross margins on pump sales in the latest month had fallen below 20%, well below the company's planned gross margin of 35% Flow controllers were devices that controlled the rate and direction of flow of chemicals They required more components and more labor, than pumps or valves, for each finished unit Also, there was much more variety in the types of flow controllers used in industry, so many more production runs and shipments were performed for this product line than for valves Wilkerson had recently raised flow controller prices by more than 10% with no apparent effect on demand Wilkerson had always used a simple cost accounting system Each unit of product was charged for direct material and labor cost Material cost was based on the prices paid for components under annual purchasing agreements Labor rates, including fringe benefits, were $25 per hour, and were charged to products based on the standard run times for each product (see Exhibit 3) The company had only one producing department, in which components were both machined and assembled into finished products The overhead costs in this department were allocated to products as a percentage of production-run direct labor cost Currently, the rate was 300% Since direct labor cost had to be recorded anyway to prepare factory payroll, this was an inexpensive way to allocate overhead costs to products Knight noted that some companies didn't allocate any overhead costs to products, treating them as period, not product, expenses For these companies, product profitability was measured at the contribution margin level - price less all variable costs Wilkerson's variable costs were only its direct material and direct labor costs On that basis, all products, including pumps, would be generating substantial contribution to overhead and profits She thought that perhaps some of Wilkerson's competitors were following this procedure and pricing to cover variable costs Knight had recently led a small task force to study Wilkerson's overhead costs since they had now become much larger than the direct labor expenses The study had revealed the following information: Workers often operated several of the machines simultaneously once they were set up For other operations, however, workers could operate only one machine Thus machinerelated expenses might relate more to the machine hours of a product than to its productionrun labor hours 2 A set-up had to be performed each time a batch of components had to be machined in a production run Each component in a product required a separate production run to machine the raw materials or purchased part to the specifications for the product People in the receiving and production control departments ordered, processed, inspected, and moved each batch of components for a production run This work required about the same amount of time whether the components were for a long or a short production run, or whether the components were expensive or inexpensive The work in the packaging and shipping area had increased during the past couple of years as Wilkerson increased the number of customers it served Each time products were packaged and shipped, about the same amount of work was required, regardless of the number of items in the shipment Knight's team had collected the data shown in Exhibit based on operations in March 2000 The team felt that this month was typical of ongoing operations Some people recalled, however, that when demand was really heavy last year, the machines had worked 12,000 hours in a month and the factory handled up to 180 production runs and 400 shipments without experiencing delays or use of overtime -Exhibit 1: Wilkerson Company: Operating Result (March 2000) Sales $2,152,500 Direct Labor Expense 271,250 Direct Materials Expense 458,000 100% Manufacturing overhead Machine-related expenses $336,000 Setup labor 40,000 Receiving and product control 180,000 Engineering 100,000 Packaging and shipping 150,000 Total Manufacturing Overhead 806,000 Gross Margin $617,250 General, Selling & Admin Expense 559,650 Operating Income (pre-tax) $57,600 29% 3% Exhibit Product Profitability Analysis (March 2000) Valves Direct labor cost per unit Flow Controllers Pumps $10.00 $12.50 $10.00 Direct material cost per unit 16.00 20.00 22.00 Manufacturing overhead (x300%) 30.00 37.5 30.00 Standard unit costs $56.00 $70.00 $62.00 Target selling price $86.15 $107.69 $95.38 35% 35% 35% Actual selling price $86.00 $87.00 $105.00 Actual gross margin (%) 34.9% 19.5% 41.0% Planned gross margin Exhibit Product Data Product Lines Valves Pumps Flow Controllers components components 10 components 2x$2 = $4 2x = 12 2x$2 = $4 2x7 = 14 4x$1 = $4 5x = 10 1x8 = $16 $20 $22 40 DL hours 50 DL hours 40 DL hours Direct labor $/unit @ $25/DL hour (including employee benefits) $10 $12.50 $10.00 Machine hours per unit 0.5 0.5 0.3 Materials per unit Materials cost per unit Direct labor per unit Exhibit Monthly Production and Operating Statistics (March 2000) Valves Production (units) Machine hours Production runs Number of shipments Hours of engineering work Pumps 7,500 3,750 10 10 250 12,500 6,250 50 70 375 Flow Controllers 4,000 1,200 100 220 625 Total 24,000 11,200 160 300 1,250 Assignment Questions (Wilkerson Company) What is the competitive situation faced by Wilkerson? Given some of the apparent problems with Wilkerson's cost system, should executives abandon overhead assignment to products entirely by adopting a contribution margin approach in which manufacturing overhead is treated as a period expense? Why or why not? How does Wilkerson's existing cost system operate? Develop a diagram to show how costs flow from factory expense accounts to products Develop and diagram an activity-based cost 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 any shifts in cost and profitability? OUR SOLUTION Introduction Wilkerson is a company that supplied products to manufacturers of water purification equipment The products that are supplied by the Wilkerson company are pumps, flow controllers and valves Especially, pumps are commodity products, produced in high volume for a market with high price competition Executive summary Wilkerson currently faces declining profit margins related to industry competitors The price cutting by the competitors led to a drop of Wilkerson's pre-tax margin to under 3% gross margin on sales for pump sales has fallen below 20% The serve industry has price cutting in pumps business which is Wilkerson’s major product line, has badly affected the company's margins (Gross Margin of 19.5% as against a planned gross margin of 35% ) On the other hand the flow controllers division was performing above the expected profits (yielding a Gross Margin of 41%, a value higher than 35% estimated) Valves are standard, produced and shipped in large lots and gross margin has been maintained at 35% Wilkerson's existing cost system is a traditional value-based costing system Direct costs are based on the price Overhead costs are figured proportionately to the direct labor costs at the rate of 300% Wilkerson needs to identify the proper mix of its product line to regain its profitability This is to be done based on information provided in the case, regarding pricing decisions, decision to discontinue or continue a product and product design A detailed analysis of the problems faced by Wilkerson Company is as follows Based on the operating results of March 2000, we can see that the company has grouped its overhead into cost items which is:  Machine-related expenses  Receiving and production control  Setup labor cost  Engineering  Packaging and shipment What is the competitive situation faced by Wilkerson? The competitive situation is different between the products Wilkerson is operating in a highly competitive market, in the industry of valves and pumps, where no company can control its supply and price level In a competitive market, each firm must sell its products at a market price; otherwise, it would lose its market share Similarly, Wilkerson has no alternative but to sell its products at a given market price to maintain sales volume Pumps are Wilkerson's major product line, produced in high volumes for a market with high price competition Wilkerson’s competitors have cut prices on their pumps, so Wilkerson also cut the price of their pumps to maintain market share, which dropped the company's pre-tax margin to under 3%, gross margin on sales for pump sales has fallen below 20% Conversely, Valves was the product line developed by Wilkerson with high quality that brought it a loyal customer base Even if several competitors could match Wilkerson's quality of valves, none had tried to gain market share by cutting prices Therefore, the competitive situation for valves was not so fierce that Wilkerson could operate at more than 35% gross margin ratio as expected Flow controllers are customized products, sold in a less competitive market with inelastic demand at the current price range Therefore, Wilkerson can increase the price of their flow controllers by 10% without apparent effect on demand 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 The 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) Given some of the apparent problems with Wilkerson's cost system, should executives abandon overhead assignment to products entirely by adopting a contribution margin approach in which manufacturing overhead is treated as a period expense? Why or why not? First, the biggest problem faced by Wilkerson's executives was to figure out the profitability of each product line Therefore, they must try to allocate overhead to each product line as detailed as possible, which means that treating the entire overhead as a period expense was not a wise decision Contribution margin approach is calculated by subtracting all variable costs from sales revenues In this case, variable costs only include direct materials and direct labor costs; hence, all products would be generating substantial contributions to overheads Using this approach for the pricing of the products is flawed, as pricing would mean only to cover the variable costs Moreover, treatment of manufacturing overhead entirely as a period expense is flawed The overheads which have cost drivers, like machine hours, production runs, production units and hours of engineering work, should be considered as product costs Allocating these overheads as period expense would result in high margin as most of the product costs and variable costs are considered period costs In addition, pricing of the products on this contribution margin approach would result in lower sales price of the products, negatively affecting the profits of the company All in all, it is not a good choice for Wilkerson to abandon overhead assignment to products entirely by adopting a contribution margin approach in which manufacturing overhead is treated as a period expense How does Wilkerson's existing cost system operate? Develop a diagram to show how costs flow from factory expense accounts to products Wilkerson Company currently uses the traditional volume-based costing system Annual purchasing agreements are used to purchase components used in the manufacture of various products Direct material costs are based on the cost of these components purchased under such agreements Direct materials and labor costs are calculated using standard prices of materials and labor rates (from Exhibit 2) The direct labor costs, $10 per hour, were allocated to the products based on the number of direct labor hours per unit All the products are assembled and machined into finished products in a single manufacturing department Because direct labor costs had to be recorded to prepare department payroll, the company is using a low-cost method of allocating overhead costs in this department to the product 300% of the production-run direct labor cost is allocated to the products as an overhead Table (using data from Exhibit 2) Product # of Units Valves Flow Controllers Total 12,500 4,000 24,000 Direct Labor 75,000 156,250 =7,500 x 10 40,000 271,250 Direct Material 120,000 250,000 = 7,500x16 88,000 458,000 195,000 = 406,250 75,000 + 120,000 128,000 729,250 225,000 468,750 = 75,000x3 120,000 813,750 (806,000) 420,000 = 875,000 195,000+225,000 248,000 1,543,000 Total Direct Costs Overhead Costs (300% of DL) Total Cost Allocation 7,500 Pumps Develop and diagram an activity-based cost 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 any shifts in cost and profitability? Wilkerson has used volume-based product costing systems (using a volume-based cost driver - direct labor cost) to allocate overhead cost to products Overhead costs are charged as 300% of direct labor cost This implies overheads are applied directly in relation to labor costs However, overheads have different components with different drivers for each as calculated Therefore, relating the overheads to the products on the basis of percentage of product run direct labor cost gives unreliable information during decision making Moreover, since overheads are very high, they are significant contributors to decision making in this costing method This method is not reliable since each product varies significantly in its overhead’s costs association Activity-based costing (ABC) systems allocate factory overhead to products using a cause-and-effect criterion with multiple cost drivers, both volume-based and non-volumebased It reflects the relationship between the volume of production of individual products and the level of overheads It can be said that 'machine hours' is the appropriate cost driver for the machine-related expenses: cost pool and setup and receiving as well as production control activities are changed in proportion to the number of production runs Engineering cost is driven by hours of engineering work and lastly packaging and shipment activity changes in proportion to the number of shipments Table - Cost Pools -> Cost Drivers -> Activity-Based Cost Rate Cost pool Amount ($) Cost Driver Amount Activity-Based Cost Rate Machine Related Expenses 336,000 Machine hours Setup labor 40,000 Production runs 160 production runs $250 per production run Receiving and production control 180,000 Production runs 160 production runs $1,125 per production run Engineering 100,000 Hours of engineering work 1,250 engineering hours $80 per engineering hour Packaging and shipping 150,000 Number of shipments 300 shipments $500 per shipment 11,200 $30 per machine hour machine hours (=336,000/11,200) Table shows us with the information about lots of activities on which we have based the costing basically cost pools, drivers of the relevant cost pools and the rate of the costing which should be considered Table - Activity-Based Cost Calculation per product(using data from Exhibit 4) Product Valves Units Pumps Flow Controllers 7,500 12,500 4,000 Direct Labor 75,000 =$10 x 7,500 156,250 =$12.50 x 12,500 40,000 = $10 x 4,000 Direct Material 120,000 = $16 x 7,500 250,000 = 12,500 x $20 88,000 = 4,000 x 22.00 Total Direct Costs 195,000= 75,000 + 120, 000 406,250 128,000 = 156,250 + 250,000 = 40,000 + 88,000 Manufacturing Overheads 112,500 = $30 x 3,750 187,500 = $30 x 6,250 36,000 = $30 x 1,200 2,500 =$250 x 10 12,500 = $250 x 50 25,000 = $250 x 100 11,250 = $1,125 x 10 56,250 = $1,125 x 50 112,500 = $1,1250 x 100 - Engineering 20,000 = $80 x 250 30,000 = $80 x 375 50,000 = $80 x 625 - Packaging and shipping 5,000 = $500 x 10 35,000 = $500 x 70 110,000 = $500 x 220 151,250 = 112,500+2,500+ 11,250+20,000 +5,000 321,250 =187,500+12,500+ 56,250+30,000+ 35,000 333,500 = 36,000+ 25,000 +112,500+50,000 +110,000 - Machine Related Expenses - Setup labor - Receiving and production control Total Manufacturing Overheads Total Cost Allocation 346,250 = 195,000+151,250 727,500 461,500 = 406,250+321,250 =128,000+333,500 In order to carry out an activity-based costing so that we can find the relevant costs associated with each product, we the Activity-Based Cost Calculation per product based on costing for the individual cost pools (in table 3) which were defined in table Exhibit provides us with the data relating to the monthly product and operating statistic which can be combined with the costs for each cost pool derived in table to give us the Activity-Based Cost Calculation per product 10 Table 4- Comparing the costings method Valves Existing Direct Materials Direct Labor Flow Controllers Pumps ABC Existing $16.00 $16.00 10.00 10.00 ABC $20.00 $20.00 12.50 12.50 Existing ABC $22.00 $22.00 10.00 10.00 Overhead 300% of DL$ 30.00 37.50 Machine 30.00 15.00 15.00 9.00 Set-up 0.33 1.00 6.25 Receiving & Product Control 1.50 4.50 28.13 Packaging & Shipping 0.67 2.80 27.50 Engineering 2.67 2.40 12.50 Total Overhead 30.00 20.17 37.50 25.70 30.00 Total Cost 56.00 46.17 70.00 58.20 62.00 115.38 Planned Gross Margin Target Selling Price Actual Selling Price Actual Gross Margin 35% 86.15 35% 71.03 86.00 34.9% 107.69 89.54 87.00 46.3% 19.5% 33.1% 83.38 35% 95.38 177.50 105.00 41% -9.9% *Note: Give Valves as an example for making clear the result in the table above It’s similar to the two remaining figures, pumps and flow controllers  Overhead: (Valves)  Machine: 15,00 = 112,500 : 7500  Set up labor: 0,33 = 2,500 : 7500  Receiving and production control: 1,50 = 11,250 : 7500  Packing and shipping: 0,67 = 5000: 7500 11   Engineering: 2,67 = 20,000 : 7500 Actual Gross Margin (Valves): 46,3% = (86 - 46,17) : 86 x 100% The data obtained from table enables us to arrive at table which compares two different costing methods, existing costing system and activity-based cost system As we can see from table above, Valves have the highest operating profit margin followed by pumps earning much more than the expected margin of the company, with 46,3% for valves and 33,1% for pumps The flow controllers which were considered highly profitable are making losses at the given price point as they have a negative gross margin of -9.90% When looking at the gross margins in Exhibit in this case, Valves had a margin of 34.9%, Pumps 19.5% and Flow controllers 41% Therefore, we can realize that the redistribution of profit happens because of the reallocation of the overheads based on the drivers giving a closer to reality costs The shifts in costs and profitability are caused by the change of cost method to allocate the indirect costs, from the traditional system to the ABC system Traditional costing depends upon a single overhead pool For this case of Wilkerson, the overhead costs to product were allocated according to 300% of production run direct labor cost, with the manufacturing overhead per unit of pumps was $12.50 x 300% = $37.5 while the figure for Flow Controllers as well as valves was $10.00 x 300% = $30.00 However, with 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, while that of flow controllers is $83.38, almost triple the number under traditional costing So, the changing of the cost method led to the result of changing the value of overhead However, the figure for the direct cost including direct material cost and direct labor cost were constant To conclude, it made a shift in cost and profitability by using the ABC system instead of the traditional one because the total cost was the sum of the direct cost and the overhead 12