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 2,340 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 5,425 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			$	217.00
Cost per drum:
Direct materials	$52.10
Direct labor ($35 per hour)	7.00
Manufacturing overhead	14.70
Selling and administrative expense	33.20			107.00
Margin per drum			$	110.00

Management believes 7,325 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 4,425 WVD-type drums per year at a price of $189 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 1,940 bike frames per year to bike manufacturers at a price of $324 each. The accounting department has provided the following data concerning the proposed new product:

Bike Frames
Selling price per frame			$	324.00
Cost per frame:
Direct materials	$109.60
Direct labor ($18 per hour)	56.00
Manufacturing overhead	53.00
Selling and administrative expense	61.40			280.00
Margin per frame			$	44.00

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 $3.00 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

1	No
	Margin computed by the accounting department is not useful for decision making since the cost includes allocated fixed common costs that are irrelavant to decision making
2	Assuming direct labor is a fixed cost,
	Contribution margin per unit:
					Purchased WVD drums	Manufactured WVD drums	Manufactured Bike frames
	Selling price			a	217	217	324
	Less; Variable costs
	Materials				189	52.1	109.6
	Direct labor				0	0	0
	Variable manufacturing overhead				0	1.35	1.9
	Variable selling and administrative				0.75	0.75	3
	Total variable cost			b	189.75	54.2	114.5
	Contribution margin per unit			(a-b)	27.25	162.8	209.5
3	Contribution margin per welding hour:
					Manufactured WVD drums	Manufactured Bike frames
	Contribution margin per unit			a	162.8	209.5
	Welding hours per unit			b	0.4	0.5
	Contribution margin per welding hour (a/b)				407	419
4
a.	Ranking of alternatives based on contribution margin per hour:
					Manufactured WVD drums	Manufactured Bike frames
	Contribution margin per welding hour (a/b)				407	419
	Rank				2	1
	Preference should be given to manufacturing bike frames
	Total hours available=2340 hours
	Demand for Bike frames=1940 frames
	Welding hours per unit=0.50
	Welding hours used for bike frames=1940*0.50=970 hours
	Balance welding hours available=2340-970=1370 hours
	Welding hours per unit for WVD drums=0.40
	Drums can be produced=1370/0.40=3425 Drums
	Demand for WDV drums=7325 drums
	Rest of the drums can be purchased from outside
	Drums to be purchased=7325-3425=3900 drums
			Purchased	Manufactured
	WVD drums		3900	3425
	Bike frames		0	1940
b.	Increase in net operating income:
					Units	Contribution margin per unit	Total contribution
	Manufactured WVD drums				3425	162.8	557590
	Purchased WVD drums				3900	27.25	106275
	Bike frames produced				1940	209.5	406430
	Total						1070295
	Less: Current contribution margin				5425	162.8	883190
	Increase in net operating income						187105