Management Accounting for Multinational Companies
Solution to the Wilkerson Case
Taking into account the difference among product and high proportion of overheads, Wilkersonshould abandon its existing cost system and move to activity-based costing. The profitability analysisindicates 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 atcost reduction (changes in flow controllers design or in their production and delivery process) orraising the price of flow controllers for customers. Since flow controllers are customized, thecompany can set different prices for different customers (groups of customers) based on the actualamount of resources spent (e.g. implement activity-based pricing).
Wilkerson has to estimate the profitability of its products in order to make long-term product mixdecisions. These decisions should be based on estimation of product costs and might includedecisions to continue / stop production of a particular product, pricing decisions, and decisionsconcerning product and process design, including customer relations.
Information about direct labor and material costs as well as overhead costs is available. Overheadsare 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.
The competitive situation varies for Wilkerson’s products. Pump and flow controllers are on theopposite sides of the spectrum. Pumps are commodity products, produced in high volumes for amarket 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 thisleadership 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-runWilkerson should be prepared to compete on price. Existing (pumps) and potential (valves) pricecompetition pushes Wilkerson to analyze its overhead costs, since no reserves of cost cutting are leftin 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 arebased on standard prices of materials and labor rates. Indirect cost (overhead) is allocated to costobjects (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 unitcost:
* Overheads are quite high (300% to direct labor cost).
* Products vary in terms of consumption of indirect resources. Pumps and valves are standardproducts, whereas flow controllers are customized, so we should expect higher unit cost for thelatter. 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 inproportion 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 orreject an additional order when only those costs that would change if a particular option is taken arerelevant). In the long-run under price competition, however, the company...