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 2,000 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. The financial data provided by the accounting department is enough to make the decision
2. Contribution margin per unit assuming direct labour is a fixed cost
	Purchase WVD Drums	Manufacture WVD Drums	Manufacture Bike frames
Selling Price	$149	$149	$239
Variable Cost:
Direct Material	$138	$52.10	$99.40
Variable manugacturing overhead	$0	$1.35	$1.90
Variable selling and administrative expenses	$0.75	$0.75	$1.30
Total Variable Cost	$138.75	$54.20	$102.60
Contribution margin	$10.25	$94.80	$136.40
3. Contribution Margin per welding hour assuming direct labour is a fixed cost
	Manufacture WVD Drums	Manufacture Bike frames
Contribution margin per unit	$94.80	$136.40
Welding hours per unit	0.4	0.5
Contribution margin per welding hour	$237.00	$272.80
4. a. Number of WVD drums that should be purchased and number of WVD drums/bike frames
that should be manufactured
As the contribution margin is high for manufacture of bike frames per welding hour, it is suggested
to first manufacture the bike frames and then WVD drums from remaining welding hours and buy WVD
drums for any unsatisfied WVD drums demand
Total Hours available	2000 hours
Bike frames produced (1600 x 0.5 hours)	800 hours
Remaining welding hours	1200 hours
WVD drums produced (1200 hours/0.4 hour)	3000 units
WVD drums buy	3000 units
4. b. Increase (decrease) in net operating income that would result from this plan over current operations
Total Contribution from bike frames (1600 x $136.40)	$218,240
Total Contribution from WVD Drums manufacture
(3000 x $94.80)	$284,400
Total Contribution from WVD drums buy
(3000 x $10.25)	$30,750
Total contribution from this plan	$533,390
Less: Total contribution from current operation
(5000 x $94.80)	$474,000
Increase in net operating income	$59,390
5. Contribution margin per unit assuming direct labour is variable cost
	Purchase WVD Drums	Manufacture WVD Drums	Manufacture Bike frames
Selling Price	$149	$149	$239
Variable Cost:
Direct Material	$138	$52.10	$99.40
Direct Labour	$0	$3.60	$28.80
Variable manugacturing overhead	$0	$1.35	$1.90
Variable selling and administrative expenses	$0.75	$0.75	$1.30
Total Variable Cost	$138.75	$57.80	$131.40
Contribution margin	$10.25	$91.20	$107.60
6. Contribution margin per welding hour assuming direct labour is a variable cost
	Manufacture WVD Drums	Manufacture Bike frames
Contribution margin per unit	$91.20	$107.60
Welding hours per unit	0.4	0.5
Contribution margin per welding hour	$228.00	$215.20
7. a. Number of WVD drums that should be purchased and number of WVD drums/bike frames
that should be manufactured
Here the previous conclusion is reversed, and if we assume direct labour hour as a variable cost
production of WVD drums is more profitable per welding hour
Total Hours available	2000 hours
WVD Drums Manufacture (2000 hours/0.4 hour)	5000 units
WVD drums buy	1000 units
7. b. Increase (decrease) in net operating income that would result from this plan over current operations
Total Contribution from WVD Drums manufacture
(5000 x $91.20)	$456,000
Total Contribution from WVD drums buy
(1000 x $10.25)	$10,250
Total contribution from this plan	$466,250
Less: Total contribution from current operation
(5000 x $91.20)	$456,000
Increase in net operating income	$10,250
It is recommended to assume labour cost is a fixed cost and decide accordingly to maximize the net income