Question

Case 12-32 Make or Buy Decisions; Volume Trade-Off Decisions [LO12-1, LO12-3, LO12-5]

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 2,000 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 5,000 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			$	149.00
Cost per drum:
Direct materials	$52.10
Direct labor ($18 per hour)	3.60
Manufacturing overhead	4.50
Selling and administrative expense	29.80			90.00
Margin per drum			$	59.00

Management believes 6,000 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 4,000 WVD-type drums per year at a price of $138 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 1,600 bike frames per year to bike manufacturers at a price of $239 each. The accounting department has provided the following data concerning the proposed new product:

Bike Frames
Selling price per frame			$	239.00
Cost per frame:
Direct materials	$99.40
Direct labor ($18 per hour)	28.80
Manufacturing overhead	36.00
Selling and administrative expense	47.80			212.00
Margin per frame			$	27.00

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 $1.30 per bike frame.

All of the company’s employees—direct and indirect—are paid for full 40-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-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. For making any decision related to products, we should consider Marginal Profit. Total cost becomes irrelevant, when it comes to decision making whether to manufacture WVD drums or Bike frame.

For this, we should calculate marginal profit (contribution) of Drums and Bike frame separately.

2. Contribution Margin Per unit (Direct Labor cost - Fixed):

Drum (Manufactured):

Selling Price 149.00

Less: Material cost -52.10

Less: Variable Manufacturing Overheads -1.35

Less: Variable Selling Overhead -0.75

Contribution Per Unit 94.80 per drum

Drum (Purchased):

Selling Price 149.00

Less: Purchase Price -138.00

Less: Variable Selling Overhead -0.75

Contribution Per Unit 10.25 per drum

Bike Frame

Selling Price 239.00

Less: Material cost -99.40

Less: Variable Manufacturing Overheads -1.90

Less: Variable Selling Overhead -1.30

Contribution Per Unit 136.40 per Bike frame

3. Contribution per Welding Hour

Drum:

Contribution per unit 94.80

Per drum Welding Hour 0.4 Hrs

Hence Per welding hour Contribution 94.80 / 0.4 = 237$ per welding hour

Bike Frame

Contribution per unit 136.40

Per drum Welding Hour 0.5 Hrs

Hence Per welding hour Contribution 136.4 / 0.5 = 272.80$ per welding hour

Now on the basis of above calculation, Bike Frame contribution per unit and per welding hour, both is higher than Drum.

Hence for higher profit, we should produce more bike frames, but we need to consider demand constraints also, as the Company has demand of drums 6,000 but of bike frames only 1,600.

4. Now in this question, we need to consider the following facts :

a) As the Weding Hours are limited, hence contribution per welding hour becomes relevant rather than contribution per unit.

In this case, Bike frame contribution per welding hour is higher than drums, hence welding capacity first be utilised for manufacturing Bike Frames.

Total Yearly Demand of Bike Frames 1,600 Units

Per Bike Frame, welding hour 0.5 Hr.

Total welding hour utilised in Bike frame = 1,600 x 0.5 = 800 Hrs.

Total Welding Hours available 2,000 Hrs.

Less: Welding Hours utilised in Bike frames -800 Hrs.

Welding Hours available for WVD Drums 1,200 Hrs.

Per Drum, welding Hours 0.4 Hr.

Hence Drum can be manufactured = 1,200/0.4 = 3,000 Drums

As total demand demand of drums is 6,000, hence another 3,000 drums, company should purchase.

4(b) : Change in Net operating income (if current plan changed)

As per existing plan, we are producing 5,000 Drums and 1,000 drums are purchased from outside.

In this case, Marginal income (total contribution) of the Company will be as under -

(5,000 x 94.80) + (1,000 x 10.25) = 484,250 $

Total contributions as per revised plan =

(1,600 x 136.40) + (3,000 x 94.80) + (3,000 x 10.25) = 533,390 $

Hence, net increase in Operating Income = 533,390 - 484,250 = 49,140$

5. If Direct Labor is variable cost, then contribution per unit -

Drums = 94.80 - 3.60 = 91.20 per unit

Bike Frame = 136.40 - 28.80 = 107.60 per unit

In case of purchased drums, margin would be same.

6. Contribution per welding hour (If direct labor is variable) -

Drums Contribution per welding hour = 91.20 / 0.4 = 228 $ per welding hour

Bike Frame contribution per welding hour = 107.60 / 0.5 = 215.20 $ per welding hour

7.(a)

As in this case, if direct labor is treated as variable cost, then contribution per welding hour of Drum is higher than Bike frame.

Now, we need to summarise the facts -

> Contribution per unit of Drum is lower than of Bike Frame

> Contribution per welding hour of drum is higher than of Bike frame.

If we compare above both situation, then of, course, we should utilise the capacity for producing Drums.

But, interesting fact is there, that we have an option to purchase drum also.

Now we should compare like this,

Contribution per welding hour of drum is higher by $ 12.80 ($228.00-$215.20)

It means, equal to 2.5 drums welding hours (2.5 drums can be produced in one welding hour) is higher by $12.80, this 2.5 drums capacity can be fulfilled by purchase option, which will give a margin of 2.5 x 10.25 = $25.62

Hence we should produce Bike frame first, then utilise the remaining capacity for drums and remaining demand of drums should be fulfilled by purchase option.

Hence units manufacturing plan will be same as was in when we were treating Direct Labor as a fixed cost (1,600 Bike frame, 3,000 Drums manufacturing and remaining 3,000 drums purchase)

7(b)

Change in Net operating income (if current plan changed)

As per existing plan, we are producing 5,000 Drums and 1,000 drums are purchased from outside.

In this case, Marginal income (total contribution) of the Company will be as under -

(5,000 x 91.20) + (1,000 x 10.25) = 466,250 $

Total contributions as per revised plan =

(1,600 x 107.60) + (3,000 x 91.20) + (3,000 x 10.25) = 476,510 $

Hence, net increase in Operating Income = 476,510 - 466,250 = 10,260$