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 2,200 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 2,750 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 $ 176.00      Cost per drum:     Direct materials $46.40     Direct labor ($18 per hour) 4.50     Manufacturing overhead 5.05     Selling and administrative expense 17.30 73.25      Margin per drum $ 102.75       Management believes 3,250 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 1,900 WVD-type drums per year at a price of $150 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 3,700 bike frames per year to bike manufacturers at a price of $77 each. The accounting department has provided the following data concerning the proposed new product: Bike Frames   Selling price per frame $ 77.00      Cost per frame:     Direct materials $19.40     Direct labor ($18 per hour) 22.50     Manufacturing overhead 17.65     Selling and administrative expense 8.40 67.95      Margin per frame $ 9.05       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 $1.24 per WVD drum and $2.50 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 $1.04 per WVD drum whether made or purchased and would be $2.30 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: PART1. 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 OR NO PART2. 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.) Contribution Margin a. Purchased WVD drums per unit b. Manufactured WVD drums per unit c. Manufactured bike frames per unit PART3. 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.) Contribution Margin Manufactured WVD drums per hour Manufactured bike frames per hour 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] Purchased Manufactured WVD drums Bike frames c. What is the increase in net operating income that would result from this plan over current operations? (Do not round intermediate calculations.) Increase in net operating income______________ PART4. 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.) Contribution Margin Purchased WVD drums per unit Manufactured WVD drums per unit Manufactured bike frames per unit b. Compute the contribution margin per welding hour for [assume direct labor is a variable cost]: (Round your final answers to 2 decimal places.) Contribution Margin Manufactured WVD drums per hour Manufactured bike frames per hour 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] Purchased Manufactured WVD drums Bike frames d. What is the increase in net operating income that would result from this plan over current operations? (Do not round intermediate calculations.) Increase in net operating income

Answer 1

Since, there are multiple parts to the question and Part 3 has multiple subparts. I have answered the first three parts.

_____

Part 1)

No, I wouldn't be comfortable with the financial data provided by the accounting department for making decisions related to the WVD drums and bike frames. Information on product margins is provided after adjustments for fixed costs which are not relevant to decision making in the given case. Adjustments for fixed costs would have resulted in lower product margins which infact is not true. Further, the profitability has not been determined with reference to the constrained resource. Applicability of constraints would determine the actual profitability/margins that may be derived with the use of constrained resource.

_____

Part 2)

The contribution margin per unit is determined as below:

	Purchased WVD Drums	Manufactured WVD Drums	Manufactured Bike Frames
Selling Price	176.00	176.00	77.00
Variable Costs:
Direct Materials	150.00	46.40	19.40
Variable Manufacturing Overhead	0.00	1.24	2.50
Variable Selling and Administrative	1.04	1.04	2.30
Total Variable Cost	151.04	48.68	24.20
Contribution Margin Per Unit	$24.96	$127.32	$52.80

_____

Tabular Representation as Required in Question:

		Contribution Margin
a.	Purchased WVD Drums	$24.96	per unit
b.	Manufactured WVD Drums	$127.32	per unit
c.	Manufactured Bike Frames	$52.80	per unit

_____

Part 3)

a)

The contribution margin per welding hour is calculated as below:

	Manufactured WVD Drums	Manufactured Bike Frames
Contribution Margin Per Unit (A)	127.32	52.80
Welding Hours Per Unit (B)	0.80	0.20
Contribution Margin Per Welding Hour (A/B)	$159.15	$264.00

_____

Tabular Representation as Required in Question:

	Contribution Margin
Manufactured WVD Drums	$159.15	per hour
Manufactured Bike Frames	$264.00	per hour

_____

b)

As the contribution margin of bike frames is higher, the company should manufacture as many bike frames it can sell with the use of available hours. The remaining hours (after production of bike frames) should be used to manufacture WVD drums. The number of bike frames and WVD drums to be purchased and manufactured are calculated as below:

Total Bike Frames to be Produced = Number of Bike Frames that Can be Sold = 3,700 units (as company has sufficient hours to produce the number of bike frames required)

Total Bike Frames to be Purchased = 0 units

Total WVD Drums to be Produced = Hours Left after Producing Bike Frames/Time Required Per WVD Drum = (2,200 - 3,700*.20)/.80 = 1,825 units

Total WVD Drums to be Purchased = Total WVD Drums that Can be Sold - Total WVD Drums to be Produced = 3,250 - 1,825 = 1,425 units

_____

Tabular Representation as Required in Question:

	Purchased	Manufactured
WVD Drums	1,425	1,825
Bike Frames	0	3,700

_____

c)

The net increase in operating income is calculated as below:

	Quantity (C)	Contribution Margin Per Unit (D)	Total Contribution (C*D)
Bike Frames to be Produced	3,700	52.80	195,360.00
WVD Drums - Make	1,825	127.32	232,359.00
WVD Drums - Buy	1,425	24.96	35,568.00
Total Contribution			463,287.00
Less Contribution Margin from Current Operations	2,750	127.32	350,130.00
Increase in Net Operating Income			$113,157.00