Wilkerson Case Study

1. The competitive situation is different between the products. Pumps are commodity products, produced in high volumes for a market with high price competition - price cutting by competitors led to a drop of Wilkersons pre -tax margin to under 3%, gross margin on sales for pump sales has fallen below 20%. Flow controllers are customized products, sold in a less competitive market with inelastic demand at the current price range. Valves are standard, produced and shipped in large lots - gross margins have been maintained at 35%. 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. The problem in the current pricing method used by Wilkerson is that the real manufacturing cost of each product is not realistic because of the high proportion of overhead costs which are 806,000 of 1,535,250 (52.5%) The current method assumes the overhead costs are correlated to the labor costs at 300% rate, while many of the overhead activities are performed per product line regardless of the amount of units produced. The approach of treating the overhead expenses as a period expense, suggests that the product cost and profitability will be measured without overhead costs (by increasing the profitability margins). This means there is a correlation between the variable costs (labors and materials) to the product price. The method doesn't consider the different activities performed for each product line. Although in a lucky way better reflects the real cost of the products, giving more weight of the overhead costs to the Flow Controllers, just because their material price is higher, but not

from the real reason (higher activity costs), this solution is not good from similar reasons like the current method.

3. Wilkerson's existing cost system of is the traditional volume-based costing: Direct materials and labor costs are based on standard prices of materials and labor rates. In addition, the manufacturing overhead is also considered as cost and it is allocated in proportion to direct labor cost at the rate of 300% (Based on the assumption that theres a direct relationship between volume of production of individual products and level of overhead).

Product # of Units Direct Labor Direct Material Total Direct Costs Overhead Costs (300% of DL) Total Cost Allocation

Valves 7500 75000 120000 195000 225000 420000

Pumps 12500 156250 250000 406250 468750 875000

Flow Controllers 4000 40000 88000 128000 120000 248000

Total 24000 271250 458000 729250 813750 (806000) 1543000

4. As overhead costs are not in proportion with the volume of production output the cost system Wilkerson is using at the moment is an inappropriate method that leads to wrong assumptions when analyzing profitability and therefore leads to wrong pricing decisions and ineffective cost management. Activity based costing helps to find the real relationship between the volume of production of a product and the overhead. In a first step it is necessary to define cost pools and find the drivers of those costs. In Wilkersons case the different pools would be machine related expenses, set up labor, receiving and production control, packaging and shipping and engineering. The related cost drivers are machine hours, production runs, hours of engineering work and number of shipments. Table 1 - Cost Pools -> Cost Drivers -> Activity-Based Cost Rate

Cost Pool

Amount ($)

Cost Driver

Amount

Activity-Based Cost Rate

Machine Related Expenses Setup labour Receiving and production control Engineering Packaging and shipping

336,000 40,000 180,000

Machine hours Production runs Production runs Hours of engineering work Number of shipments

11,200 machine hours $30 per machine hour 160 production runs 160 production runs 1,250 engineering hours 300 shipments $250 per production run $1,125 per production run $80 per engineering hour $500 per shipment

100,000 150,000

Table 2 - Activity-Based Cost Calculation per product (using data from Exhibit 4)

Product Valves Units 7500 Direct Labour 75,000 Direct Material 120,000 Total Direct Costs 195,000 Manufacturing Overheads - Machine Related 112,500 Expenses - Setup labour 2,500 - Receiving and 11,250 production control - Engineering 20,000 - Packaging and 5,000 shipping Total Manufacturing 151,250 Overheads Total Cost Allocation 346,250

Pumps 12500 156,250 250,000 406,250

Flow Controllers 4000 40,000 88,000 128,000

187,500 12,500 56,250 30,000 35,000 321,250 727,500

36,000 25,000 112,500 50,000 110,000 333,500 461,500

From table 3 we can see that flow controllers are not contributing in a positive way as they have a negative gross margin of -9.90%. While Valves have a higher margin (46.3%) and also Pumps have a higher gross margin with 33.1%. Vales and Pumps are therefore actually much more attractive for the company than they had expected while Flow controllers contributes a negative gross margin.

Table 3 Comparing between costing methods

Method Product Unit Produced Standard Unit Cost Planned Gross Margin Target Selling Price Actual Selling Price Actual Gross Margin

Existing Cost System

Valves Pumps Flow Controllers

Activity-Based Cost System

Valves Pumps Flow Controllers

7500 $56.00 35%

12500 $70.00 35%

4000 $62.00 35%

7500 $46.17 35%

12500 $58.20 35%

4000 $115.38 35%

$86.15

$107.69

$95.38

$71.03

$89.54

$177.50

$86.00

$87.00

$105.00

$86.00

$87.00

$105.00

34.9%

19.5%

41.0%

46.3%

33.1%

-9.9%

Using cost drivers for the calculation gives much more accurate information about the actual production costs. When looking at the gross margins in Exhibit 2 in the case Valves had a margin of 34.9%, Pumps a margin of 19.5% and Flow controllers of 41%. Therefore you can deduct that Pumps and Valves are more attractive for the company than they actually thought. The shifts in costs and profitability are caused of the change of cost method, to a method which is more accurate.

5. The first thing to take care of is the Flow Controllers, as the Wilkerson's management team can take advantage of the favorable competitive situation in this market which is the inelastic demand and the lack of competition, and therefore raise their price up to the range between 116-177.5, depends on the market reaction (even if the previous 10% price raise didn't damaged the sales, a 50% raise may damage them). Also the management team can compete in the price competition on the valves and pumps to maintain and maybe increase their market share , although an exam should be made in order to check if the price decrease will harm the profit. 6. The cost calculations in question 4 are sensitive to the utilization of the product line. We based our numbers on the information of March 2000, which is mentioned as a typical month, but it is also mentioned that on months of high demand machines worked 12,000 hours, factory handled 180 production runs and 400 shipments The cost calculations would be best achieved if we based it on past years demands charts which include seasonal shifts in demands. The cost of the resources and labor can also change during time and should be updated for accurate cost calculation. 7. The current salespersons incentive system, based on volumes only, drives the salespersons to maximize their sales regardless Wilkerson's profit. There are 2 main problems1. The salespersons will want to sell for the lowest price they can, in order to increase their sales volume. 2. If the Company has several product lines, the salespersons do not necessarily have the incentive to sell the most profitable products, but only the products generating maximal volumes. I recommend on changing the incentive system to compensation on the profit generated from each sale, based on the known values of cost of each product using Activity-Based Costs. In this way the interests are similar and the salespersons will gain more when the company will profit more.