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 2,400 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 3,000 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		$	170.00
Cost per drum:
Direct materials	$46.60
Direct labor ($18 per hour)	4.50
Manufacturing overhead	5.25
Selling and administrative expense	17.50		73.85
Margin per drum		$	96.15

Management believes 3,500 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 1,500 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 3,900 bike frames per year to bike manufacturers at a price of $75 each. The accounting department has provided the following data concerning the proposed new product:

Bike Frames
Selling price per frame		$	75.00
Cost per frame:
Direct materials	$19.60
Direct labor ($18 per hour)	22.50
Manufacturing overhead	17.85
Selling and administrative expense	8.60		68.55
Margin per frame		$	6.45

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 $1.26 per WVD drum and $2.70 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 $1.06 per WVD drum whether made or purchased and would be $2.50 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.)

Answer 1

Answer 1

No, I would not be comfortable with the financial data provided by the accounting department only to form an opinion on the given case study.

I would be comfortable only if the additional information provided forms part of it.

Answer 2

			Drum - Own Prod		Drum - Outsourced		Bike Frame - Own Prod
			Amount	Amount	Amount	Amount	Amount	Amount
Selling Price				170.00		170.00		75.00
Variable Cost per drum
Outsouce cost					130.00
Direct material			46.60				19.60
Manufacturing overhead (Variable potion)			1.26				2.70
Selling and administrative			1.06		1.06		2.50
Variable Cost per drum				48.92		130.00		24.80
Contribution per unit				121.08		40.00		50.20

Answer 3 (all parts)

			Drum - Own Prod		Drum - Outsourced		Bike Frame - Own Prod
			Amount $	Amount $	Amount $	Amount $	Amount $	Amount $
Selling Price				170.00		170.00		75.00
Variable Cost per drum
Outsouce cost					130.00
Direct material			46.60				19.60
Manufacturing overhead (Variable potion)			1.26				2.70
Selling and administrative			1.06		1.06		2.50
Variable Cost per drum				48.92		131.06		24.80
Contribution per unit				121.08		38.94		50.20
Bottleneck resource (Wielding hrs) / unit				0.80		NA		0.20
Contrubution per unit of Bottleneck resource				151.35		NA		251.00
Ranking order based on bottleneck resource				2				1
Assignment of Bottleneck Resource
	Units	Hr/unit	Hrs
Bottleneck Resource Hours Available			2400
Assigned to Bike Frame - based on Ranking order	3900	0.2	780
Balance available			1620
Remaining assigned to drum	2025	0.8	1620
Drums units to be produced/Outsourced
	New Units	Old Units	Add/(Less)
Total Demand	3500
Drums - Own production	2025	3000	(975)
Hence, Drums Outsourced	1475	0	1475
Computation of Increase in Net Operating income
	Unit	Contribution/unit	Total $
Additional Contribution from Bike Frame	3900	50.20	195,780.00
Additional Contribution from Drum - Outsourced	1475	38.94	57,436.50
Contribution foregone from Drum - Own production	(975)	121.08	(118,053.00)
Net Increrase in Operating income			135,163.50