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 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.

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 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 225000 468750 120000 813750 (806000)

(300% of DL)
Total Cost 420000 875000 248000 1543000
Allocation

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 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
 Amount
Cost Pool ($) Cost Driver Amount Activity-Based Cost Rate

Machine Related Expenses 336,000 Machine hours 11,200 machine hours $30 per machine hour

Setup labour 40,000 Production runs 160 production runs $250 per production run

Receiving and production $1,125 per production

180,000 Production runs 160 production runs
control run

Hours of engineering 1,250 engineering $80 per engineering

Engineering 100,000
work hours hour

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

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

Product Valves Pumps Flow Controllers

Units 7500 12500 4000
Direct Labour 75,000 156,250 40,000
Direct Material 120,000 250,000 88,000
Total Direct Costs 195,000 406,250 128,000
Manufacturing
Overheads
- Machine Related
112,500 187,500 36,000
Expenses
- Setup labour 2,500 12,500 25,000
- Receiving and
11,250 56,250 112,500
production control
- Engineering 20,000 30,000 50,000
- Packaging and
5,000 35,000 110,000
shipping
Total Manufacturing
151,250 321,250 333,500
Overheads
Total Cost
346,250 727,500 461,500
Allocation
 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 Existing Cost System Activity-Based Cost System

Product Valves Pumps Flow Valves Pumps Flow
Controllers Controllers
Unit
7500 12500 4000 7500 12500 4000
Produced
Standard
$56.00 $70.00 $62.00 $46.17 $58.20 $115.38
Unit Cost
Planned
Gross 35% 35% 35% 35% 35% 35%
Margin
Target
Selling $86.15 $107.69 $95.38 $71.03 $89.54 $177.50
Price
Actual
Selling $86.00 $87.00 $105.00 $86.00 $87.00 $105.00
Price
Actual
Gross 34.9% 19.5% 41.0% 46.3% 33.1% -9.9%
Margin
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 problems-

1. 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.