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 2,100 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 2,625 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		$	168.00
Cost per drum:
Direct materials	$45.20
Direct labor ($18 per hour)	4.50
Manufacturing overhead	3.85
Selling and administrative expense	16.10		69.65
Margin per drum		$	98.35

Management believes 3,125 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 $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 3,600 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	$18.20
Direct labor ($18 per hour)	22.50
Manufacturing overhead	16.45
Selling and administrative expense	7.20		64.35
Margin per frame		$	7.65

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 $1.12 per WVD drum and $1.30 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 $0.92 per WVD drum whether made or purchased and would be $1.10 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

Answer 1.
The product margins computed by the Company for the drums and bike frames should not be used in the decision making of the which product is produced. The product margin is lower due to allocated fixed common costs that are irrelevant in decision making. Moreover, decision should be made on the constraint resource i.e, Welding Time.
Answer 2.
Assume Direct Labor is Fixed Cost
	Purchase WVD Drum	Manufactured
		WVD Drums	Bike Frames
Selling Price	168.00	168.00	72.00
Variable Costs
Direct materials	130.00	45.20	18.20
Variable Manf. Overhead	-	1.12	1.30
Variable Selling & Admn. Exp.	0.92	0.92	1.10
Total Variable Cost	130.92	47.24	20.60
Contribution Margin	37.08	120.76	51.40
Answer 3.a.
	Manufactured
	WVD Drums	Bike Frames
Contribution Margin	120.76	51.40
Welding Hour per Unit	0.80	0.20
Contribution Margin per welding Hour	150.95	257.00
Answer 3.b & c.
Since, the Contribution margin per welding hour (constrained resouce) of Bike Frames is more than WVD Drums, so Bike frames must be produced up to the demand level. The demand of the WVD Drum can be met by purchasing the WVD Drum from outside supplier.
	Quantity	Unit Contribution Margin	Welding Time per unit	Total Welding Time	Balance of Welding time	Total Conbtribution
Total hours available					2,100
Bikes Frames Produced	3,600	51.40	0.20	720	1,380	185,040.00
WVD - drums Make	1,725	120.76	0.80	1,380	-	208,311.00
WVD - drums Buy	1,400	37.08	-	-	-	51,912.00
Total Contribution Margin						445,263.00
Less: Contribution Margin from Current operations - WVD Drums - 2,625 Nos X $120.76						316,995.00
Inceased Contrbution Margin & Net Operating Income						128,268.00
	Purchased	Manufactured
WVD Drums	1,400	1,725
Bike Frames		3,600
Incerase in Net operating Income	128,268.00
Answer 4. a.
Assume Direct Labor as Variable Cost
	Purchase WVD Drum	Manufactured
		WVD Drums	Bike Frames
Selling Price	168.00	168.00	72.00
Variable Costs
Direct materials	130.00	45.20	18.20
Direct Labor	-	4.50	22.50
Variable Manf. Overhead	-	1.12	1.30
Variable Selling & Admn. Exp.	0.92	0.92	1.10
Total Variable Cost	130.92	51.74	43.10
Contribution Margin	37.08	116.26	28.90
Answer 4. b.
	Manufactured
	WVD Drums	Bike Frames
Contribution Margin	116.26	28.90
Welding Hour per Unit	0.80	0.20
Contribution Margin per welding Hour	145.33	144.50
Answer 4.b & c.
In this case, the decision is totally reversed. The company should manufactured WVD drums as many as possible and after that some welding hours is left, the Bike frame to be produced
	Quantity	Unit Contribution Margin	Welding Time per unit	Total Welding Time	Balance of Welding time	Total Conbtribution
Total hours available					2,100
WVD - drums Make	2,625	116.26	0.80	2,100	-	305,182.50
WVD - drums Buy	500	37.08	-	-	-	18,540.00
Total Contribution Margin						323,722.50
Less: Contribution Margin from Current operations - WVD Drums - 2625 Nos X $116.25						305,182.50
Inceased Contrbution Margin & Net Operating Income						18,540.00
	Purchased	Manufactured
WVD Drums	500	2,625
Bike Frames		-
Incerase in Net operating Income	18,540.00