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 2,500 hours of welding time is available annually on the machine. Because each drum requires 0.8 hours of welding machine time, annual production is limited to 3,125 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		$	162.00
Cost per drum:
Direct materials	$45.00
Direct labor ($18 per hour)	4.50
Manufacturing overhead	3.65
Selling and administrative expense	15.90		69.05
Margin per drum		$	92.95

Management believes 3,625 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 1,700 WVD-type drums per year at a price of $130 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 0.2 hours of welding machine time per frame and yet sell for far more than the drums. Megan believes that TufStuff could sell up to 3,400 bike frames per year to bike manufacturers at a price of $70 each. The accounting department has provided the following data concerning the proposed new product:

Bike Frames
Selling price per frame		$	70.00
Cost per frame:
Direct materials	$18.00
Direct labor ($18 per hour)	22.50
Manufacturing overhead	16.25
Selling and administrative expense	7.00		63.75
Margin per frame		$	6.25

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 $1.10 per WVD drum and $1.10 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 $0.90 per WVD drum whether made or purchased and would be $.90 per bike frame.

All of the company’s employees—direct and indirect—are paid for full 40-hour workweeks and the company has a policy of laying off workers only in major recessions.

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?

	Yes
	No

2. Compute the contribution margin per unit for [assume direct labor is a fixed cost]: (Do not round intermediate calculations. Round your answers to 2 decimal places.)

3. 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-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.

a. Compute the contribution margin per welding hour for [assume direct labor is a fixed cost]: (Round your final answers to 2 decimal places.)

b. 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 fixed cost]

c. What is the increase in net operating income that would result from this plan over current operations? (Do not round intermediate calculations.)

4. Redo requirements (2) and (3) making the opposite assumption about direct labor from the one you originally made. In other words, if you treated direct labor as a variable cost, redo the analysis treating it as a fixed cost. If you treated direct labor as a fixed cost, redo the analysis treating it as a variable cost.

a. Compute the contribution margin per unit for [assume direct labor is a variable cost]: (Do not round intermediate calculations. Round your answers to 2 decimal places.)

b. Compute the contribution margin per welding hour for [assume direct labor is a variable cost]: (Round your final answers to 2 decimal places.)

c. 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]

d. What is the increase in net operating income that would result from this plan over current operations? (Do not round intermediate calculations.)

Answer 1

PART 1

Answer is NO

It is suggested that the calculations of product margins by the accounting department for the drums and bike frames should not be applied in the decision of whether to produce WVD drums or bike frames. Due to the presence of allocated fixed common costs, the product margins are lower than they should be so they are irrelevant in this decision. Moreover, the profitability of the two products in relation to the amount of the constrained resource-welding time, should also be considered. In nutshell, the financial data offered by the accounting department does not seem to be important for making this decision.

PART 2

Assuming direct labor is fixed

		manufactured
	Purchased WVD drums	WVD drums	Bike frames
Selling price	162.00	162.00	70
Variable costs:
Direct materials	130	45.00	18.00
Variable manufacturing overhead	0.00	1.10	1.10
Variable selling and administrative	0.90	0.90	0.90
Total variable cost	130.90	47.00	20.00
Contribution margin	31.10	115.00	50.00

PART 3 (A)

	manufactured
	WVD drums	Bike frames
Contribution margin	115.00	50.00
Welding hours per unit	0.8	0.2
Contribution margin per welding hour	143.75	250.00

PART 3 (B)

As the Contribution margin per welding hour of bike frames is higher, it is more profitable to produce bike frames. Thus, the company should manufacture as many bike frames as possible and if there is any remaining capacity, it should go for WDV drums.

PART 3 (c)

	Quantity (A)	Unit Contri-bution Margin (B)	Welding Time per Unit (C)	Total Welding Time (AXC)	Balance of Welding Time	Total Contri-bution (AXB)
Total hours available					2500
Bike frames produced	3400	50.00	0.20	680	1820	170000.00
WVD Drums—make	2275	115.00	0.80	1540	0	261625.00
WVD Drums—buy	2275	31.10				70752.50
Total contribution margin						502377.50
Less: Contribution margin from present operations: 3125 drums × $115 CM per drum						359375
Increased contribution margin and net operating income						143002.50

Quantity of WDV drums = (total welding time – welding time for bike framses)/welding time per unit of WDV drums = (2500-680)/0.80 = 2275

PART 4 (A)

Assuming direct labor is variable

		manufactured
	Purchased WVD drums	WVD drums	Bike frames
Selling price	162.00	162.00	70
Variable costs:
Direct materials	130	45.00	18.00
Direct labor	0	4.50	22.50
Variable manufacturing overhead	0.00	1.10	1.10
Variable selling and administrative	0.90	0.90	0.90
Total variable cost	130.90	51.50	42.50
Contribution margin	31.10	110.50	27.50

PART 4(B)

	manufactured
	WVD drums	Bike frames
Contribution margin	110.50	27.50
Welding hours per unit	0.8	0.2
Contribution margin per welding hour	138.13	137.50

When direct labor is taken as variable cost, the results completely reversed. In this case, the WVD drums seems to be a better use of the constraint than the bike frames. This shows that the assumption about the behavior of direct labor really does matter.

PART 4(C)

	Quantity (A)	Unit Contri-bution Margin (B)	Welding Time per Unit (C)	Total Welding Time (AXC)	Balance of Welding Time	Total Contri-bution (AXB)
Total hours available					2500
WVD Drums—make	3125	110.50	0.80	2500	0	345312.50
Bike frames produced	0	27.50	0.20	1540	0	0
WVD Drums—buy	1425 (3125-1700)	31.10				44317.50
Total contribution margin						389630.00
Less: Contribution margin from present operations: 3125 drums × $110.50 CM per drum						345312.50
Increased contribution margin and net operating income						44317.50

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 is presented in the calculation.