Wilkerson Company mainly manufactures water purification equipment. The company’s profitability is resulting from the finished goods of pumps, valves, and flow controllers. However, the company has been experiencing the decline in profits. The overall pre-tax operating income has decreased from a historical rate of 10% to less than 3%.
Production process of Wilkerson Company can be simplified into three stages. The company first purchases the semi-finished components from suppliers. Then it machines these component parts and assembles them in the manufacturing facility. The production runs are scheduled to match ...view middle of the document...
The problem for this existing cost system that the company is inappropriately allocating overhead cost to products. Due to this poor allocation, the manufacturing cost of each product is not very accurate. The proportion of overhead cost is unrealistically high. The proportion of the overhead cost weighs 52.5%. (806,000/1,535,250) In addition, the manufacturing overhead is considered as cost and allocated in proportion to direct labor cost of 300%.
Treating the overhead costs as a period expense suggests that the product profitability will be measured without overhead costs, which means, there is a correlation between the variable costs to the product price. Following this approach makes the pricing to cover variable costs (direct materials and direct labors).
The Activity-Based Costing is the method of matching costs to activities. It will provide better strategic decisions compared to the current cost accounting system. The Activity-Based Costing method will define cost pools and cost drivers. So for Wilkerson Company, cost pools would be machine expenses, set up labor, production control, engineering, packaging, and shipping. The related cost drivers would be machine hours, production runs, number of shipments, and hours of engineering work. Based on these information, the ABC system will look like this:
Table 1. (ABC Rates)
Cost Pool | Amount ($) (a) | Cost Driver | Amount (b) | ABC Rate = (a)/(b) |
Machine Expenses | $336,000 | Machine hours | 11200 hrs | $30 per machine hr |
Setup Labor | $40,000 | Production runs | 160 runs | $250 per p. run |
R & P control | $180,000. | Production runs | 160 runs | $1125 per p. run |
Engineering | $100,000 | Number of shipments | 1250 hr | 80 per hr |
Packaging and Shipping | $150,000 | Hours of engineering work | 300 shipments | $500 per shippment |
This table shows how the Activtiy Based Cost rates are calculated. The amount from the cost pool divided by the cost driver gives the cost rate for ABC rate. After calculating the rate of Activity Based Cost, we now can calculate Activity Based Cost for each product.
Table 2. (ABC cost per product)
Product | Valves | Pumps | Flow controllers |
Units | 7500 | 12500 | 4000 |
Direct Labor | $75,000 | $156,250 | $40,000 |
Direct Material | $120,000 | $250,000 | $88,000 |
Total | $195,000 | $406,250 | $128,000 |
| | | |
Machine Expenses | $112,500 | $187,500 | $36,000 |