Question

TufStuff, Inc., sells a wide range of drums, bins, boxes, and other containers that are used in the chemical industry. One of the company’s products is a heavy-duty corrosion-resistant metal drum, called the WVD drum, used to store toxic wastes. Production is constrained by the capacity of an automated welding machine that is used to make precision welds. A total of 2,140 hours of welding time is available annually on the machine. Because each drum requires 0.4 hours of welding machine time, annual production is limited to 5,175 drums. At present, the welding machine is used exclusively to make the WVD drums. The accounting department has provided the following financial data concerning the WVD drums:

WVD Drums
Selling price per drum			$	177.00
Cost per drum:
Direct materials	$52.10
Direct labor ($25 per hour)	5.00
Manufacturing overhead	8.70
Selling and administrative expense	31.20			97.00
Margin per drum			$	80.00

Management believes 6,275 WVD drums could be sold each year if the company had sufficient manufacturing capacity. As an alternative to adding another welding machine, management has considered buying additional drums from an outside supplier. Harcor Industries, Inc., a supplier of quality products, would be able to provide up to 4,175 WVD-type drums per year at a price of $159 per drum, which TufStuff would resell to its customers at its normal selling price after appropriate relabeling.

Megan Flores, TufStuff’s production manager, has suggested that the company could make better use of the welding machine by manufacturing bike frames, which would require only 0.5 hours of welding machine time per frame and yet sell for far more than the drums. Megan believes that TufStuff could sell up to 1,740 bike frames per year to bike manufacturers at a price of $274 each. The accounting department has provided the following data concerning the proposed new product:

Bike Frames
Selling price per frame			$	274.00
Cost per frame:
Direct materials	$103.60
Direct labor ($18 per hour)	40.00
Manufacturing overhead	43.00
Selling and administrative expense	53.40			240.00
Margin per frame			$	34.00

The bike frames could be produced with existing equipment and personnel. Manufacturing overhead is allocated to products on the basis of direct labor-hours. Most of the manufacturing overhead consists of fixed common costs such as rent on the factory building, but some of it is variable. The variable manufacturing overhead has been estimated at $1.35 per WVD drum and $1.90 per bike frame. The variable manufacturing overhead cost would not be incurred on drums acquired from the outside supplier.

Selling and administrative expenses are allocated to products on the basis of revenues. Almost all of the selling and administrative expenses are fixed common costs, but it has been estimated that variable selling and administrative expenses amount to $.75 per WVD drum whether made or purchased and would be $2.00 per bike frame.

All of the company’s employees—direct and indirect—are paid for full 40.00-hour work weeks and the company has a policy of laying off workers only in major recessions.

As soon as your analysis was shown to the top management team at TufStuff, several managers got into an argument concerning how direct labor costs should be treated when making this decision. One manager argued that direct labor is always treated as a variable cost in textbooks and in practice and has always been considered a variable cost at TufStuff. After all, “direct” means you can directly trace the cost to products. “If direct labor is not a variable cost, what is?” Another manager argued just as strenuously that direct labor should be considered a fixed cost at TufStuff. No one had been laid off in over a decade, and for all practical purposes, everyone at the plant is on a monthly salary. Everyone classified as direct labor works a regular 40.00-hour workweek and overtime has not been necessary since the company adopted Lean Production techniques. Whether the welding machine is used to make drums or frames, the total payroll would be exactly the same. There is enough slack, in the form of idle time, to accommodate any increase in total direct labor time that the bike frames would require.

Required:

1. Would you be comfortable relying on the financial data provided by the accounting department for making decisions related to the WVD drums and bike frames?

2. Compute the contribution margin per unit. [assume direct labor is a fixed cost]

3. Compute the contribution margin per welding hour. [assume direct labor is a fixed cost]

4. Assuming direct labor is a fixed cost:

a. Determine the number of WVD drums (if any) that should be purchased and the number of WVD drums and/or bike frames (if any) that should be manufactured.

b. What is the increase (decrease) in net operating income that would result from this plan over current operations?

5. Compute the contribution margin per unit. [assume direct labor is a variable cost]

6. Compute the contribution margin per welding hour. [assume direct labor is a variable cost]

7. Assuming direct labor is a variable cost:

a. Determine the number of WVD drums (if any) that should be purchased and the number of WVD drums and/or bike frames (if any) that should be manufactured. [Assume direct labor is a variable cost]

b. What is the increase (decrease) in net operating income that would result from this plan over current operations?

Answer 1

Solution 1:

No, the Product margin as computed by accounting Department should not be used to make decision because it has considered allocated fixed costs also and fixed costs are irrelevant for such decisions. Variable costs should be considered while decision making.

Solution 2:

Computation of Contribution margin per unit (Assuming Direct Labor is Fixed cost)
		Manufactured
	Purchased WVD drums	WVD drums	Bike frames
Selling price	$177.00	$177.00	$274.00
Variable costs:
Direct materials	$159.00	$52.10	$103.60
Variable manufacturing overhead	$0.00	$1.35	$1.90
Variable selling and administrative	$0.75	$0.75	$2.00
Total variable cost	159.75	54.2	$107.50
Contribution margin per unit	$17.25	$122.80	$166.50

Solution 3:

Computation of Contribution margin per welding hour
	Manufactured
	WVD drums	Bike frames
Contribution margin per unit	$122.80	$166.50
Welding hours per unit	0.4	0.5
Contribution margin per welding hour	$307.00	$333.00
Ranking	2	1

Solution 4a:

Compuation of WVD drums and/or bike frames to be manufactured/ purchased
	Hours Required	Hours Left
First Manufacture Bike Frames (1740*0.5 hour)	870	1270
Hours to Manufacture WVD Drums	1270	0
	Units
Manufacture Bike frames	1740
Manufacture WVD Drums (1270/ 0.4)	3175
Purchase WVD Drums (6275 - 3175)	3100

Solution 4b:

Computation of Net Operating Income resulting from this plan over current operations
	Units	CM per unit	Total CM
Bike Frames	1740	$166.50	$2,89,710
WVD Drums (Manufactured)	3175	$122.80	$3,89,890
WVD Drums (Purchased)	3100	$17.25	$53,475
Total Contribution margin from New Plan			$7,33,075
Less: Contribution margin from Current operations (5175*$122.80)			$6,35,490
Increase in Net Operating Income			$97,585

Solution 5:

Computation of Contribution margin per unit (Assuming Direct Labor is Variable cost)
		Manufactured
	Purchased WVD drums	WVD drums	Bike frames
Selling price	$177.00	$177.00	$274.00
Variable costs:
Direct materials	$159.00	$52.10	$103.60
Direct labor	$0.00	$5.00	$40.00
Variable manufacturing overhead	$0.00	$1.35	$1.90
Variable selling and administrative	$0.75	$0.75	$2.00
Total variable cost	$159.75	$59.20	$147.50
Contribution margin per unit	$17.25	$117.80	$126.50

Solution 6:

Computation of Contribution margin per welding hour
	Manufactured
	WVD drums	Bike frames
Contribution margin per unit	$117.80	$126.50
Welding hours per unit	0.4	0.5
Contribution margin per welding hour	$294.50	$253.00
Ranking	1	2

Solution 7a:

Compuation of WVD drums and/or bike frames to be manufactured/ purchased
	Hours Required	Hours Left
First Manufacture WDV Drums (5350*0.4 hour)	2140	0
Hours to Manufacture Bike frames	0	0
	Units
Manufacture WVD Drums	5350
Purchase WVD Drums (6275 - 5350)	925

Solution 7b:

Computation of Net Operating Income resulting from this plan over current operations
	Units	CM per unit	Total CM
WVD Drums (Manufactured)	5350	$117.80	$6,30,230
WVD Drums (Purchased)	925	$17.25	$15,956
Total Contribution margin from New Plan			$6,46,186
Less: Contribution margin from Current operations (5175*$117.80)			$6,09,615
Increase in Net Operating Income			$36,571