OVERVIEWIn the Wilkerson Company, the main issue is, the company isfacing a pre-tax operating margin of 3% compared to historical rate of 10%. Thecompany used simple Overhead Absorption Rate (OAR) for accounting manufacturingoverheads. It is charged to different products unit cost based on the direct labourhour spent after OAR is obtained by dividing the total manufacturing overheadsby the total activity level. The OAR is 300%. It appears that Flow controllershave the highest actual gross margin of 41.0%; followed by valves, 34.9% andpumps, 19.
5%. The OAR reflects the company’s major product line – pumps, tohold direct responsibility on the overall poor income performance, mainly dueto its continuous price reduction to compete against the market. The flowcontrollers recorded the least units produced and yet required the highestproduction runs, shipments and engineering works.
This product line also beingcharged at low manufacturing overheads comparing to pumps, by reason of its lowdirect labour cost. Considering Activity-Based Costing (ABC), the company’sactivities level and allocate respective costs based on workload andexpenditure instead of assigning indirect costs to the products’ direct costs.CURRENT ISSUEManufacturing overhead (MOH) is estimated as 300% of directlabour. This is not accurate because manufacturing overhead has sub componentssuch as machine related expenses, setup labour, engineering etc which areattributable to different activities. Instead of following a cost volume profitanalysis for allocation of the manufacturing overhead, the company can followABC analysis to have a more accurate cost allocation.ANALYSIS OF THECURRENT SYSTEMMOH assignment Valves – $30Pumps – $37.50Flow controllers – $30Under CVP approach, it is assumed MOH is directly related todirect labour (i.
e. MOH increases if direct labour increases). But in reality,it is not happening as the machine related expenses would be related to machinehours rather than direct labour.ACTIVITY BASED COSTAPPROACHUnder ABC approach the MOH’s sub components are allocated tothe product on the basis of the activity to which they are related to.Here, in Wilkerson company, the MOH sub components can beallocated on the basis of the following activities.
Machine related expenses – machine hoursSet up labour – production runsReceiving and production control – production runsEngineering – hours of engineering workPackaging and shipping – number of shipments ALLOCATION OF MOHUNDER ABC APPROACH machine related expenses set up labour receiving and production control engineering packaging and shipping CVP ABC CVP ABC CVP ABC CVP ABC CVP ABC – 112500 – 2500 – 11250 – 20000 – 5000 – 187500 – 12500 – 56250 – 30000 – 35000 – 36000 – 25000 – 112500 – 50000 – 110000 336000 366000 40000 40000 180000 180000 100000 100000 150000 150000 PRODUCT PROFITABILITYANALYSIS valves pumps FC CVP ABC CVP ABC CVP ABC direct labour cost 10 10 12.5 12.5 10 10 direct material cost 16 16 20 20 22 22 MOH 30 20.17 37.5 25.7 30 83.
38 standard unit cost 56 46.17 70 58.2 62 115.38 actual selling price 86 86 87 87 105 105 actual gross margin 34.90% 46.30% 19.50% 33.
10% 41% -9.90% Under CVP approach, Flow controllers had the highest margin.But under ABC approach, the gross margin of Flow controllers is negative. Itcan be seen that valves are the actual products which has the highest grossmargin.Thus, Activity based cost calculation gives a more accurateresult in cost calculation that CVP approach.