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 $ 161.00 Cost per drum: Direct materials $45.90 Direct labor ($18 per hour) 4.50 Manufacturing overhead 4.55 Selling and administrative expense 16.80 71.75 Margin per drum $ 89.25 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 1,700 WVD-type drums per year at a price of $140 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 3,200 bike frames per year to bike manufacturers at a price of $72 each. The accounting department has provided the following data concerning the proposed new product: Bike Frames Selling price per frame $ 72.00 Cost per frame: Direct materials $18.90 Direct labor ($18 per hour) 22.50 Manufacturing overhead 17.15 Selling and administrative expense 7.90 66.45 Margin per frame $ 5.55 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 $1.19 per WVD drum and $2.00 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 $0.99 per WVD drum whether made or purchased and would be $1.80 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

Ans 1. Yes. The data provided by the accounting dept can be relied upon.

Ans 2. Contribution Margin per unit (Assuming direct labour is a fixed cost) Particulars Drums($) Frames($) Purchased Drums($) Sales price per unit 161 72 161 (-) Variable cost Direct Materials 45.9 18.9 140 Variable Manufacturing Overhead 1.19 2 Variable Selling & Adminstrative Overhead 0.99 1.8 0.99 (Assuming zero inventory due to adoption of lean manufacturing) Total Variable Cost 48.08 22.7 140.99 Contribution Margin per unit 112.92 49.3 20.01 (Sales -Variable Cost) Ans 3(a). Contribution Margin per welding hour (Assuming direct labour is fixed cost) Particulars Drums($) Frames($) Contribution Margin per unit 45.9 18.9 (From calculation above) Welding hours per unit 0.8 0.2 Contribution Margin per welding hour 57.38 94.5 Ans 3(b). From the above calculations it is clear that the contribution margin per welding hour is more in case of frames ($ 246.5/hr) than that of drums ($ 141.15/hr). Hence we should divert the welding hours which is the bottleneck resource for production of maximum no of frames ie 3200. This consumes welding hours of 3200 X 0.2= 640 hrs. The remaining welding hours of 2200 hr- 640 hr ie 1560 hr should be utilized to produce 1560/0.8 ie 1950 units of drum. If 3250 drums is to be sold then the remaining 3250-1950 ie 1300 drums can be purchased from outside. Hence the most profitable production plan will be as follows: Frames (production)= 3200, Drums (production)=1950, Drums (outside manufacturing)=1300. Ans 4(a). Contribution Margin per unit (Assuming direct labour is a variable cost) Particulars Drums($) Frames($) Purchased Drums($) Sales price per unit 161 72 161 (-) Variable cost Direct Materials 45.9 18.9 140 Direct Labour 4.5 22.5 Variable Manufacturing Overhead 1.19 2 Variable Selling & Adminstrative Overhead 0.99 1.8 0.99 Total Variable Cost 52.58 45.2 140.99 Contribution Margin per unit 108.42 26.8 20.01 Ans 4(b). Contribution Margin per welding hour (Assuming direct labour is variable cost) Particulars Drums($) Frames($) Contribution Margin per unit 108.42 26.8 (From calculation above) Welding hours per unit 0.8 0.2 Contribution Margin per welding hour 135.53 134

Ans 4(c). As evident from the above calculation if we consider the direct labour as a variable cost the picture changes. Here the contribution margin per welding hour of drums ie $ 135.53 is higher than that of frames ie $ 134. Hence the no of drums manufactured should be 2200/0.8 ie 2750. No further machine capacity remains for frames.