Question: TufStuff, Inc., sells a wide range of
TufStuff, Inc., sells a wide range of drums, bins, boxes, and other containers that are used in thechemical 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 anautomated welding machine that is used to make precision welds. A total of 2,000 hours of weldingtime 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 exclusivelyto make the WVD drums. The accounting department has provided the following financial dataconcerning the WVD drums: 
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, managementhas considered buying additional drums from an outside supplier. Harcor Industries, Inc., a supplierof quality products, would be able to provide up to 4,000 WVD-type drums per year at a priceof $138 per drum, which TufStuff would resell to its customers at its normal selling price after appropriaterelabeling. Megan Flores, TufStuff’s production manager, has suggested that the company could make betteruse of the welding machine by manufacturing bike frames, which would require only 0.5 hoursof 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 accountingdepartment has provided the following data concerning the proposed new product: 
The bike frames could be produced with existing equipment and personnel. Manufacturingoverhead is allocated to products on the basis of direct labor-hours. Most of the manufacturingoverhead 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 $1.90per bike frame. The variable manufacturing overhead cost would not be incurred on drums acquiredfrom the outside supplier. Selling and administrative expenses are allocated to products on the basis of revenues. Almostall of the selling and administrative expenses are fixed common costs, but it has been estimated thatvariable selling and administrative expenses amount to $0.75 per WVD drum whether made orpurchased and would be $1.30 per bike frame. All of the company’s employees—direct and indirect—are paid for full 40-hour workweeksand 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 accountingdepartment, 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 innet 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 makingthis decision. One manager argued that direct labor is always treated as a variable cost intextbooks 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 LeanProduction techniques. Whether the welding machine is used to make drums or frames, thetotal payroll would be exactly the same. There is enough slack, in the form of idle time, to accommodateany 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 theone you originally made. In other words, if you treated direct labor as a variable cost, redo theanalysis treating it as a fixed cost. If you treated direct labor as a fixed cost, redo the analysistreating 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.
Transcribed Image Text:
WVD Drums Selling price per drum.... Cost per drum: Direct materials.... Direct labor ($18 per hour) Manufacturing overhead Selling and administrative expense.. Margin per drum .. $149.00 $52.10 3.60 4.50 29.80 90.00 $ 59.00
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