accounting 350 458181

CASE 13’30 Make or Buy; Utilization of a Constrained Resource [LO1, LO3, LO5]

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 fi nancial data

concerning the WVD drums:

Relevant Costs for Decision Making 623

Management believes 6,000 WVD drums could be sold each year if the company had suffi

cient 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:

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

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

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