Cost Allocation

Wilkerson Company is a fluid control devices manufacturer and they supply products to manufactures of water purification equipment. The company has established a strong brand name in the industry because of the high quality of its valves. Over the year, the company has extended their product range to pumps and flow controllers.

The main learning outcome from analyzing the case study is manufacturing overhead cost allocation. Exhibit 2 in the case study shows pumps has a highest manufacturing overhead cost compare to valves and flow controller. The common overhead cost drivers in the production are machine hours, production runs and hours of engineering work.

The key issue in this case study is the gross margin on pump sales is 19.5% that well below the company's target gross margin of 35%. If we analyze deeply the data in Exhibit 4, it clearly shows that the manufacturing process for flow controller has more activities compared to valve and pump. For example, to produce 4,000 units of flow controller, we need to consume 100 production runs and 625 hours of engineering work. However, with 50% of the production runs and 60% of the engineering work of flow controller's overhead resources, the company can produce 12,500 units of pumps. Besides that, flow controller also has a highest number of shipments per month compared to pump and valve.

This indicates that the current overhead cost allocation practice did not reflect the real costs incurred on the products. The lower actual gross profit obtained was mainly due to wrong cost allocation on the pump product.

To improve the accuracy of the manufacturing overhead cost allocation, the company should adopt the Activity-Based Costing (ABC) method. The ABC approach focuses on the activities required to produce each product and allocates cost based on that product's consumption of those activities. For example, in this case study, the ABC will trace the cost