Question

Designer Frames makes bicycle frames in two processes, tubing and welding. The tubing process has a capacity of 125,000 units per year; welding has a capacity of 150,000 units per year. Cost information follows:

Design of product and process costs	$100,000
Inspection and testing costs	42,500
Scrap cost per unit (all in the tubing dept.)	34.00

The company enjoys high demand for its products. Designer Frames can sell whatever output it can produce for the market price of $55 per frame. Designer Frames can start only 125,000 units into production in the tubing department because of capacity constraints on the tubing machines. The company scraps all defective units produced in the tubing department. Of the 125,000 units started in the tubing operation, 12,500 units (10 percent) are scrapped at the end of the production process. Scrap costs, based on total (fixed and variable) manufacturing costs incurred in the tubing operation, equal $34.00 per unit as follows:

Direct materials (variable)	$17.50
Direct manufacturing, setup, and materials handling labor (variable)	6.50
Depreciation, rent, and other overhead (fixed)	10.00
	$34.00

The “$10 fixed cost” is the portion of the total fixed costs of $1,250,000 allocated to each unit, whether good or defective. The good units from the tubing department are sent to the welding department. Variable manufacturing costs in the welding department are $2.00 per unit. There is no scrap in the welding department. Therefore, Designer Frames’ total sales quantity equals the tubing department’s output. Designer Frames incurs no other variable costs. Designer Frames’ designers have discovered that using a different type of material in the tubing operation would reduce scrap to zero, but it would increase the variable costs per unit in the tubing department by $2.25. Recall that only 125,000 units can be started each year.

Required:

1. What is the additional direct materials cost of implementing the new method?

The additional direct material cost for implementing the new method would be $2.25 per unit and a total of $281,250.

b. What is the additional benefit to Designer Frames from using the new material and improving quality?

c. Should Designer Frames use the new materials?

d. Draft brief note to management describing other nonfinancial and qualitative factors should Designer Frames consider in making the decision?

Answer 1

a) The additional direct materials cost of implementing the new method is calculated as follows:-

No of units produced during the year * Additional cost per unit

125,000 Units * $ 2.25 per unit

= $ 281,250

b) Additional benefit from using the new material and improving quality can be calculated as follows:-

• Increase in profit equivalent to contribution on defective products which can be calculated as follows:-

No of units scrapped * (Sale price/Unit - Variable cost/unit)

= 12,500 Units * ($ 55 - $ 24)

= $ 387,500

c) Yes, the designer frames should use new materials, as it will increase profit of the Company by $ 106,250 ( 387,500 - 281,250)

d) Following are the certain illustrative factors that can be considered in making the decision:-

• Improving quality will improve the goodwill of the Company amongst customers, and they may also charge certain premium for such quality in due course of time
• The Company will be able to utilize Welding department more, as the quantity transferred from Tubing department to Welding department will increase
• Inspection and Quality costs will also be gradually reduced, hence increasing the profitability in long term.
• By earning more profits, The Company can expand the capacity of tubing department, so as to increase the production and profits in turn.