assignment subject cost management

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 cu

TRUONG DAI HQC KINH TE QUOC DAN

VIEN DAO TAO TIEN TIEN, CHAT LUONG CAO VA POHE

walle

NH TE

Ay Shc

Nee”

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

1 Nguyễn Hông Thăm

2 Nguyễn Hồng Thắm

3 Nguyễn Thị Quỳnh Chi

Nguyễn Thi Hồng Ngoc

4 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 1 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:

1 Workers often operated several of the machines simultaneously once they were set

up For other operations, however, workers could operate only one machine Thus machine- related expenses might relate more to the machine hours of a product than to its production- run 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

3 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

4 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 4 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 $2,152,500 100% Direct Labor 271,250

Expense

Direct Materials Expense 458,000

Manufacturing overhead

Machine-related expenses $336,000 Setup labor 40,000

Receiving and product 180,000 control

Packaging and shipping 150,000

Total Manufacturing Overhead 806,000

Gross Margin $617,250 29%

General, Selling & Admin Expense 559,650

Operating Income (pre-tax) $57,600 3%

Exhibit 2 Product Profitability Analysis (March 2000)

Flow Valves Pumps Controllers Direct labor cost per unit $10.00 $12.50 $10.00 Direct material cost per unit 16.00 20.00 22.00

Manufacturing overhead 30.00 37.5 30.00

(x300%)

Target selling price $86.15 $107.69 $95.38

Actual selling price $86.00 $87.00 $105.00

Actual gross margin (%) 34.9% 19.5% 41.0%

Exhibit 3 Product Data

4 components 5 components 10 components

2x$2 = $4 2x$2 = $4 we

2x 6= 12 2x7 = 14 1x8 =8

Direct labor per unit AQ DL hours 50 DL hours AO DL hours Direct labor $/unit @

employee benefits)

Exhibit 4 Monthly Production and Operating Statistics (March 2000)

Flow

Valves Pumps Controllers Total Production (units) 7,500 12,500 4,000 24,000 Machine hours 3,750 6,250 1,200 11,200

Assignment Questions (Wilkerson Company)

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 assignment to products entirely by adopting a contribution margin approach in which manufacturing overhead is treated as a period expense? Why or why not?

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 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 5 cost items which is:

° Machine-related expenses

° Receiving and production control

° Setup labor cost

° Engineering

° Packaging and shipment

1 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)

2 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

3 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 1 (using data from Exhibit 2)

Controllers

=7,500 x 10 Direct Material 120,000 | 250,000 88,000 458,000

= 7,500x16 Total Direct Costs 195,000 = | 406,250 128,000 729,250

75,000 + 120,000 Overhead Costs 225,000 | 468,750 120,000 813,750

Total Cost 420,000 = | 875,000 248,000 1,543,000

Allocation 195,000+225,000

4 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-volume- based 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 2 - Cost Pools -> Cost Drivers -> Activity-Based Cost Rate

Cost pool Amount ($) | Cost Driver Amount Activity-Based Cost

Rate

Machine Related 336,000 Machine 11,200 $30 per machine hour Expenses hours machine hours (=336,000/1 1,200)

Setup labor 40,000 Production 160 $250 per production

runs Receiving and 180,000 | Production 160 $1,125 per production

Engineering 100,000 | Hours of 1,250 $80 per engineering

engineering engineering hour

Packaging and 150,000 | Number of | 300 shipments | $500 per shipment

shipping shipments

Table 2 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