Storage Systems, 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 XSX drum, used to store toxic wastes. Production is constrained by the capac- ity of an automated welding machine that is used to make precision welds. A total of 2,000 hours of welding time are available annually on the machine. Because each drum requires 0.8 hours of welding time, annual production is limited to 2,500 drums. At present, the welding machine is used exclusively to make the XSX drums. The accounting department has provided the following financial data concerning the XSX drums:
Management believes 3,000 XSX drums could be sold each year if the company had sufficient manufacturing capacity. As an alternative to adding another welding machine, management has looked into the possibility of buying additional drums from an outside supplier. Metal Products, Inc., a supplier of quality products, would be able to provide up to 1,800 XSX-type drums per year at a price of $120 per drum, which Storage Systems would resell to its customers at its normal sell- ing price after appropriate relabeling.
Jasmine Morita, Storage Systems’ production manager, has suggested that the company could make better use of the welding machine by manufacturing premium mountain bike frames, which would require only 0.2 hours of welding time per frame. Jasmine believes that Storage Systems could sell up to 3,500 mountain bike frames per year to mountain bike manufacturers at a price of $65 per frame. The accounting department has provided the following data concerning the proposed new product:
The mountain bike frames could be produced with existing equipment and personnel. Manu- facturing overhead is allocated to products on the basis of direct labor-hours. Most of the manufac- turing 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 $1.05 per XSX drum and
$0.60 per mountain 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 $0.85 per XSX drum and would be $0.40 per mountain bike frame. The variable selling and administrative expenses of $0.85 per drum would be incurred when drums acquired from the outside supplier are sold to the company’s customers.
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.
1. Given the margins of the two products as indicated in the reports submitted by the accounting department, does it make any sense to even consider producing the mountain bike frames? Explain.
2. Compute the contribution margin per unit for:
a. Purchased XSX drums.
b. Manufactured XSX drums.
c. Manufactured mountain bike frames.
3. Determine the number of XSX drums (if any) that should be purchased and the number of XSX drums and/or mountain bike frames (if any) that should be manufactured. What is the improvement in net income that would result from this plan over current operations?
As soon as your analysis was shown to the top management team at Storage Systems, 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 text- books and in practice and has always been considered a variable cost at Storage Systems. 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 Storage Systems. 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 Produc- tion 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 mountain bike frames would require.
4. Redo requirements (2) and (3) above, 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 analy- sis treating it as a variable cost.
5. What do you think is the correct way to treat direct labor in this situation—as a variable cost or as a fixed cost? Explain.
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