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).
Existing cost system

Currently Wilkerson implements volume-based full costing. Direct materials and labor costs are
based on standard prices of materials and labor rates. Indirect cost (overhead) is allocated to cost
objects (products) in proportion to direct labor cost at the rate of 300%.

Two factors demonstrate that volume-based costing may produce inadequate estimates of the unit
cost:

 Overheads are quite high (300% to direct labor cost).

 Products vary in terms of consumption of indirect resources. Pumps and valves are standard
products, whereas flow controllers are customized, so we should expect higher unit cost for the
latter. 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. Currently overheads are allocated to products in
proportion to direct labor costs, although they don’t relate to direct labor technologically.

Option I: Direct costing and Contribution analysis

Direct costing and contribution analysis are adequate for short-term decision making (e.g. accept or
reject an additional order when only those costs that would change if a particular option is taken are
relevant). In the long-run under price competition, however, the company needs to be sure that
each product is at a minimum break even.

Besides, direct costing would provide highly unreliable information for decision-making when
overheads are so significant and there is variability among products.

Option II: Activity-based costing

Activity-based costing allows tracing indirect costs to product with a high degree of accuracy. 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, activity-based costing allows
finding individual relationships between volume of production and different overheads. 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.

Wilkerson should pool overheads into five groups (cost pools): machine-related expenses, setup
labor cost, receiving and production control, engineering, packaging and shipment. The next step is
choosing most appropriate cost drivers that reflect the relationship between volume of production
of individual products and level of overheads. Machine hours are the most natural cost driver for
machine-related expenses. Both setup and receiving, and production control activities are changed
in proportion to number of production runs. Engineering cost can be allocated in proportion to
hours of engineering work, whereas packaging and shipment activity is driven by the number of
shipments.
The selected cost pools, cost drivers and calculated cost driver rates are presented below:

Activity/ Machine- Setup Labor Receiving Engineering Packaging

Cost Related and and
pool Expenses Production Shipment
Control
$336,000 $40,000 $180,000 $100,000 $150,000

Cost Machine- Production Production Hours of Number

driver hours runs runs engineering of
work shipments
11,200 160 160 1,250 300

Cost $30 / $250 / run $1,125 / run $80 / hour $500 /

driver machine- shipment
rate hour

Per unit cost of products can be found as a sum of direct labor and material costs and allocated
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).

Table 1

Product unit costs under ABC

Cost items / Products Valves Pumps Flow controllers

Direct materials $16.00 $20.00 $22.00

Direct
costs

Direct labor $10.00 $12.50 $10.00

Machine-related expenses 0.5 * 30 = $15.00 0.5 * 30 = $15.00 0.3 * 30 = $9.00
Setup labor 10 * 250 / 7,500 = 50 * 250 / 12,500 = 100 * 250 / 4,000 =
$0.33 $1.00 $6.25
Receiving and production 10 * 1,125 / 7,500 50 * 1,125 / 12,500 100 * 1,125 / 4,000
control =$ 1.50 = $4.50 = $28.13
Overheads

Engineering 250 * 80 / 7,500 = 375 * 80 / 12,500 = 625 * 80 / 4,000 =

$2.66 $2.40 $12.50
Packaging and shipping 10 * 500 / 7,500 = 70 * 500 / 12,500 = 220 * 500 / 4,000 =
$0.67 $2.80 $27.50
Total cost $46.17 $58.20 $115.38

Activity-based costing provides more accurate information about product cost and, therefore, their
gross margins. Customized product (flow controllers) appeared to be much less attractive for the
company that standardized valves and pumps. Actually, flow controllers generate negative gross
margin (under assumption made), while valves and pumps are much more profitable than the
company initially believed (see Table 2).
 Table 2

Product profitability: volume-based costing vs activity-based costing

Valves Pumps Flow controllers

Actual price $86.00 $87.00 $105.00

Volume-based costing:
- Standard unit costs $56.00 $70.00 $62.00
- Actual gross margin (%) 34.9% 19.5% 41.0%

Activity-based costing:
- Standard unit costs $46.17 $58.20 $115.38
- Actual gross margin (%) 46.3% 33.1% -9.9%

Wilkerson can continue to decrease prices of commodity products (valves and pumps) since their
margins are quite high, but need to react to negative profitability of flow controllers.

Correction for unused capacity

Variations in capacity utilization may have significant impact on unit costs of individual products and,
therefore, on decision made on the basis of full cost analysis. If the demand can be higher in some
months, and Wilkerson can still meet it, we should acknowledge the fact of having unused capacity
in the “typical month” that we consider. Higher capacity utilization will increase products’ gross
margins. Preliminary analysis indicates that flow controllers might have low, but positive margin, if
capacity utilization goes up as stated.

If we can reasonable believe that the company can actually increase the level of capacity utilization
in the long-run, cost analysis for individual products should be done on the basis of cost of used
capacity only, leaving aside cost of unused capacity. The latter, if temporary, can be subtracted from
the company’s profit along with general and administrative expenses.

Limitations of analysis

Our calculation of cost drivers and product cost doesn’t allow revealing the difference between
individual flow controllers, although we know that they are customized. So, their unit costs are
average and might vary significantly for a specific configuration (cost of production) or a specific
customer (cost of delivery).

Regular analysis of product profitability based on activity-based costing is an expensive exercise, so

we are not able to accommodate the impact of variability of volume of product on unit costs. We
assume here, that calculations are done for a representative (typical) month in terms of capacity
utilization. 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.

General and administrative expenses, although significant, weren’t allocated among products.
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, we recommend to move from traditional volume-based costing to
activity-based costing.

Based on the information about unit cost obtained by ABC we can recommend the company to
review its policy in respect to flow controllers. Having in mind the absence of price competition,
customized nature of a product, and price inelastic demand, 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.

The company can also consider a set of action that might reduce the cost of flow controllers: change
their design, adjust the production process to eliminate waste of resources, switch to batch
production and delivery to decrease the cost per unit associated with production runs and number
of shipments.