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 Wilkerson’s 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.
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 there’s a direct relationship between volume of production of individual products and level of overhead).
Product| Valves| Pumps| Flow Controllers| Total|
# of Units| 7500| 12500| 4000| 24000|
Direct Labor| 75000| 156250| 40000| 271250|
Direct Material| 120000| 250000| 88000| 458000|
Total Direct Costs| 195000| 406250| 128000| 729250|
Overhead Costs (300% of DL)| 225000| 468750| 120000| 813750 (806000)| Total Cost Allocation| 420000| 875000| 248000| 1543000|
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 Wilkerson’s 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 |...