Question

In: Accounting

TufStuff, Inc., sells a wide range of drums, bins, boxes, and other containers that are used...

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 0.4 hours of welding machine time, annual production is limited to 5,500 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 $ 229.00
Cost per drum:
Direct materials $52.10
Direct labor ($38 per hour) 7.60
Manufacturing overhead 16.50
Selling and administrative expense 33.80 110.00
Margin per drum $ 119.00

Management believes 7,400 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 4,500 WVD-type drums per year at a price of $198 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 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 2,000 bike frames per year to bike manufacturers at a price of $339 each. The accounting department has provided the following data concerning the proposed new product:

Bike Frames
Selling price per frame $ 339.00
Cost per frame:
Direct materials $111.40
Direct labor ($18 per hour) 60.80
Manufacturing overhead 56.00
Selling and administrative expense 63.80 292.00
Margin per frame $ 47.00

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 $0.75 per WVD drum whether made or purchased and would be $3.30 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 for [assume direct labor is a fixed cost]

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

6. Compute the contribution margin per welding hour for [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?

use 5,500

Solutions

Expert Solution

(1.)

No, For making decision of WVD drums or bike frames, product margins should not be used. The cost and expenses should have been correctly classified as fixed and variable too. Also profit making chances of these two products depending on welding time also needed to be taken into consideration.

(2.) *Assuming direct labor is fixed

Manufactured

Purchased WVD drums

WVD drums

Bike frames

Selling price

229 229 339

Variable costs:

Direct materials

198 52.10 111.40

Variable manufacturing overhead

0 1.35 1.9

Variable selling and administrative

0.75 0.75 3.3

Total variable cost (B)

198.75 54.20 116.6

Contribution margin (A-B)

30.25 174.80 222.40

(3.) *Assuming direct labor is fixed

Manufactured

WVD drums

Bike frames

Contribution margin per unit (a) 174.80 222.40
Welding hours per unit (b) 0.4 0.5
Contribution margin per welding hour (a) ÷ (b) $437 per hour $444.80 per hour

(4a.) *Analysis assuming direct labor is a fixed cost

(a) (b) (c) (a)*(c) (a)*(b)
Quantity Unit Contribution Margin Welding Time per Unit Total Welding Time Balance of Welding Time Total Contribution
Total hours available 2,400
Bike frames produced 2,000 222.40 0.5 1,000 1,400 $444,800
WVD Drums—make 3,500 174.80 0.4 1,400 0 $611,800
WVD Drums—buy 3,900 30.25 $117,975
Total contribution margin $1,174,575

(4b.)

Total contribution margin 1,174,575
Less: Contribution margin from present operations: 5,500 drums × $174.80 CM per drum 961,400
Increased contribution margin and net operating income 213,175

(5.) Assuming direct labor is a variable cost

Manufactured

Purchased WVD drums

WVD drums

Bike frames

Selling price

229 229 339

Variable costs:

Direct materials

198 52.10 111.40
Direct labor 0 7.60 60.80

Variable manufacturing overhead

0 1.35 1.9

Variable selling and administrative

0.75 0.75 3.3

Total variable cost (B)

198.75 61.80 177.40

Contribution margin (A-B)

30.25 167.20 161.60

(6.) *Assuming direct labor is a variable cost

Manufactured

WVD drums

Bike frames

Contribution margin per unit (a) 167.20 161.60
Welding hours per unit (b) 0.4 0.5
Contribution margin per welding hour (a) ÷ (b) $418 per hour $323.20 per hour

(7a.) *Assuming direct labor is a variable cost

(a) (b) (c) (a)*(c) (a)*(b)
Quantity Unit Contribution Margin Welding Time per Unit Total Welding Time Balance of Welding Time Total Contribution
Total hours available 2,400
Bike frames produced 5,500 167.20 0.4 2,200 200 919,600
WVD Drums—make 400 161.60 0.5 200 0 64,640
WVD Drums—buy 1,900 30.25 57,475
Total contribution margin $1,041,715

  (7b.)

Total contribution margin 1,041,715
Less: Contribution margin from present operations: 5,500 drums × $167.20 CM per drum 919,600
Increased contribution margin and net operating income 122,115

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