TufStuff, Inc., sells a wide range of drums, bins, boxes, and other containers t
ID: 2478193 • Letter: T
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 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 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 fi xed 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 fi xed 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 workweeks and the company has a policy of laying off workers only in major recessions. Required: 1. Given the margins of the two products as indicated in the reports submitted by the accounting department, does it make sense to consider producing the bike frames? Explain. 2. Compute the contribution margin per unit for: a. Purchased WVD drums. b. Manufactured WVD drums. c. Manufactured bike frames. 3. 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. What is the increase in net operating income that would result from this plan over current operations? 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 classifi ed 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. 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. 5. What do you think is the correct way to treat direct labor cost in this situation—as variable or as fixed? Explain.
Explanation / Answer
Answer:
1. The product margins computed by the accounting department for the drums and bike frames should not be used in the decision of which product to make. The product margins are lower than they should be due to the presence of allocated fixed common costs that are irrelevant in this decision. Moreover, even after the irrelevant costs have been removed, what matters is the profitability of the two products in relation to the amount of the constrained resource—welding time—that they use. A product with a very low margin may be desirable if it uses very little of the constrained resource. In short, the financial data provided by the accounting department are useless and potentially misleading for making this decision.
2. Students may have answered this question assuming that direct labor is a variable cost, even though the case strongly hints that direct labor is a fixed cost. The solution is shown here assuming that direct labor is fixed. The solution assuming that direct labor is variable will be shown in part (4).
Solution assuming direct labor is fixed
Manufactured
Purchased WVD Drums
WVD Drums
Bike Frames
Selling price.........................................................
$149.00
$149.00
$239.00
Variable costs:
Direct materials................................................
138.00
52.10
99.40
Variable manufacturing overhead.....................
0.00
1.35
1.90
Variable selling and administrative...................
0.75
0.75
1.30
Total variable cost................................................
138.75
54.20
102.60
Contribution margin.............................................
$ 10.25
$ 94.80
$136.40
3. Because the demand for the welding machine exceeds the 2,000 hours that are available, products that use the machine should be prioritized based on their contribution margin per welding hour. The computations are carried out below under the assumption that direct labor is a fixed cost and then under the assumption that it is a variable cost.
Solution assuming direct labor is fixed
Manufactured
WVD Drums
Bike Frames
Contribution margin per unit (above) (a)......................................
$94.80
$136.40
Welding hours per unit (b).............................................................................................
0.4 hour
0.5 hour
Contribution margin per welding hour (a) ÷ (b)...........................
$237.00
per hour
$272.80
per hour
Because the contribution margin per unit of the constrained resource (i.e., welding time) is larger for the bike frames than for the WVD drums, the frames make the most profitable use of the welding machine. Consequently, the company should manufacture as many bike frames as possible up to demand and then use any leftover capacity to produce WVD drums. Buying the drums from the outside supplier can fill any remaining unsatisfied demand for WVD drums. The necessary calculations are carried out below.
Analysis assuming direct labor is a fixed cost
(a)
(b)
(c)
(a) × (c)
(a) × (b)
Quantity
Unit Contri-bution Margin
Welding Time per Unit
Total Welding Time
Balance of Welding Time
Total Contri-bution
Total hours available....................................
2,000
Bike frames produced..................................
1,600
$136.40
0.5
800
1,200
$218,240
WVD Drums—make...................................
3,000
$94.80
0.4
1,200
0
284,400
WVD Drums—buy.....................................
3,000
$10.25
30,750
Total contribution margin.............................
533,390
Less: Contribution margin from present operations: 5,000 drums × $94.80 CM per drum...................................................
474,000
Increased contribution margin and net operating income......................................
$ 59,390
4. The computation of the contribution margins and the analysis of the best product mix are repeated here under the assumption that direct labor costs are variable.
Solution assuming direct labor is a variable cost
Manufactured
Purchased WVD Drums
WVD Drums
Bike Frames
Selling price......................................................
$149.00
$149.00
$239.00
Variable costs:
Direct materials.............................................
138.00
52.10
99.40
Direct labor...................................................
0.00
3.60
28.80
Variable manufacturing overhead..................
0.00
1.35
1.90
Variable selling and administrative................
0.75
0.75
1.30
Total variable cost.............................................
138.75
57.80
131.40
Contribution margin..........................................
$ 10.25
$ 91.20
$107.60
Solution assuming direct labor is a variable cost
Manufactured
WVD Drums
Bike Frames
Contribution margin per unit (above) (a)...................................
$91.20
$107.60
Welding hours per unit (b)........................................................
0.4 hour
0.5 hour
Contribution margin per welding hour (a) ÷ (b)........................
$228.00
per hour
$215.20
per hour
When direct labor is assumed to be a variable cost, the conclusion is reversed from the case in which direct labor is assumed to be a fixed cost—the WVD drums appear to be a better use of the constraint than the bike frames. The assumption about the behavior of direct labor really does matter.
Solution assuming direct labor is a variable cost
(a)
(b)
(c)
(a) × (c)
(a) × (b)
Quantity
Unit Contri-bution Margin
Welding Time per Unit
Total Welding Time
Balance of Welding Time
Total Contri-bution
Total hours available.....................................
2,000
WVD Drums—make....................................
5,000
$91.20
0.4
2,000
0
$456,000
Bike frames produced...................................
0
$107.60
0.5
0
0
0
WVD Drums—buy.......................................
1,000
$10.25
10,250
Total contribution margin..............................
466,250
Less: Contribution margin from present operations: 5,000 drums × $91.20 CM per drum....................................................
456,000
Increased contribution margin and net operating income.......................................
$ 10,250
5. The case strongly suggests that direct labor is fixed: “The bike frames could be produced with existing equipment and personnel.” Nevertheless, it would be a good idea to examine how much labor time is really needed under the two opposing plans.
Production
Direct Labor-Hours Per Unit
Total Direct Labor-Hours
Plan 1:
Bike frames..............................
1,600
1.6*
2,560
WVD drums............................
3,000
0.2**
600
3,160
Plan 2:
WVD drums............................
5,000
0.2**
1,000
* $28.80 ÷ $18.00 per hour = 1.6 hour
** $3.60 ÷ $18.00 per hour = 0.2 hour
Some caution is advised. Plan 1 assumes that direct labor is a fixed cost. However, this plan requires 2,160 more direct labor-hours than Plan 2 and the present situation. At 40 hours per week a typical full-time employee works about 1,900 hours a year, so the added workload is equivalent to more than one full-time employee. Does the plant really have that much idle time at present? If so, and if shifting workers over to making bike frames would not jeopardize operations elsewhere, then Plan 1 is indeed the better plan. However, if taking on the bike frame as a new product would lead to pressure to hire another worker, more analysis is in order. It is still best to view direct labor as a fixed cost, but taking on the frames as a new product could lead to a jump in fixed costs of about $34,200 (1,900 hours × $18 per hour)—assuming that the remaining 260 hours could be made up using otherwise idle time.
Additional Analysis:
Contribution margin from Plan 1:
Bike frames produced (1,600 × $136.40).....................................
218,240
WVD Drums—make (3,000 × $94.80).......................................
284,400
WVD Drums—buy (3,000 × $10.25)..........................................
30,750
Total contribution margin.............................................................
533,390
Less: Additional fixed labor costs....................................................
34,200
Net effect of Plan 1 on net operating income...................................
$499,190
Contribution margin from Plan 2:....................................................
WVD Drums—make (5,000 × $94.80).......................................
$474,000
WVD Drums—buy (1,000 × $10.25)..........................................
10,250
Net effect of Plan 2 on net operating income...................................
$484,250
If an additional direct labor employee would have to be hired, Plan 1 is still optimal.
Solution assuming direct labor is fixed
Manufactured
Purchased WVD Drums
WVD Drums
Bike Frames
Selling price.........................................................
$149.00
$149.00
$239.00
Variable costs:
Direct materials................................................
138.00
52.10
99.40
Variable manufacturing overhead.....................
0.00
1.35
1.90
Variable selling and administrative...................
0.75
0.75
1.30
Total variable cost................................................
138.75
54.20
102.60
Contribution margin.............................................
$ 10.25
$ 94.80
$136.40
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