The main issue faced by Wilkerson Company is that a pre-tax
operating margin of 3% compared to historical rate of 10%. The company used
simple Overhead Absorption Rate (OAR) for accounting manufacturing overheads. Its
charged to different products on a unit cost basis on the direct labour hour
spent after OAR is obtained by dividing total manufacturing overheads by total
activity level. OAR = 300%. It is observed that Flow controllers have the
highest actual gross margin of 41%, followed by valves = 34.9% and pumps = 19.5%.
OAR reflects the company’s major product line – pumps, to hold direct
responsibility on the overall poor income performance, mainly because of its
continuous price reduction to compete against the market. The flow controllers
recorded the least units produced and yet required the highest production runs,
shipments and engineering works. This product line also being charged at low
manufacturing overheads comparing to pumps, by reason of its low direct labour
cost. Considering Activity-Based Costing (ABC), the company’s activity level
and allocate respective costs based on workload and expenditure instead of
assigning indirect costs to the products’ direct costs.
Manufacturing overhead is estimated as 300% of direct
labour. This is not accurate because manufacturing overhead has sub components
such as machine related expenses, setup labour, engineering etc which are
attributable to different activities. Instead of following a CVP analysis for
allocation of the manufacturing overhead, the company can follow ABC analysis
to have a more accurate cost allocation.
ANALYSIS OF THE
Valves – $30
Pumps – $37.50
Flow controllers – $30
Under CVP approach, it is assumed manufacturing overhead is
directly related to direct labour (i.e. manufacturing overhead increases if
direct labour increases). But in reality, it is not happening as the machine
related expenses would be related to machine hours rather than direct labour.
ACTIVITY BASED COST
Under ABC approach the manufacturing overhead’s sub
components are allocated to the product on the basis of the activity to which
they are related to.
Here, in Wilkerson company, the MOH sub components can be
allocated on the basis of the following activities.
Machine related expenses – machine hours
Set up labour – production runs
Receiving and production control – production runs
Engineering – hours of engineering work
Packaging and shipping – number of shipments
ALLOCATION OF MOH
UNDER ABC APPROACH
machine related expenses
set up labour
receiving and production control
packaging and shipping
direct labour cost
direct material cost
standard unit cost
actual selling price
actual gross margin
Under CVP approach, Flow controllers had the highest margin.
But under ABC approach, the gross margin of Flow controllers is negative. It
can be seen that valves are the actual products which has the highest gross
Thus, Activity based cost calculation gives a more accurate
result in cost calculation that CVP approach.