Metal Works produces a wide range of products for use in the chemical

industry. One of the companys products is a heavy-duty corrosion-resistant

metal drum, called the MW15 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 2,200 hours of welding time is available

annually on the machine. Because each drum requires 0.8 hours of welding

machine time, annual production is limited to 2,750 drums. At present, the

welding machine is used exclusively to make the MW15 drums. The

accounting department has provided the following financial data concerning

the MW15 drums:

MW15 Drums

Selling price per drum

$

156.00

Cost per drum:

Direct materials

$44.70

Direct labor ($18 per hour)

4.50

Manufacturing overhead

3.35

Selling and administrative

expense

15.60

68.15

Margin per drum

$

87.85

Management believes 3,250 MW15 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 2,000 MW15-

type drums per year at a price of $140 per drum, which Metal Works would

resell to its customers at its normal selling price after appropriate

relabeling.

Susan Fontane, Metal Works production manager, has suggested that

the company could make better use of the welding machine by

manufacturing bike frames, which would require only 0.2 hours of welding

machine time per frame and yet sell for far more than the drums. Susan

believes that Metal Works could sell up to 3,100 bike frames per year to

bike manufacturers at a price of $67 each. The accounting department has

provided the following data concerning the proposed new product:

Bike Frames

Selling price per frame

$

67.00

Cost per frame:

Direct materials

$17.70

Direct labor ($18 per hour)

22.50

Manufacturing overhead

15.95

Selling and administrative

expense

6.70

62.85

Margin per frame

$

4.15

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 $1.07

per MW15 drum and $0.80 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 $0.87 per MW15 drum whether made or

purchased and would be $0.60 per bike frame.

All of the companys employeesdirect and indirectare paid for full

40-hour workweeks and the company has a policy of laying off workers only

in major recessions.

Required (if you want any partial credit, make sure you show your

work):

1.

Would you be comfortable relying on the financial data provided by

the accounting department for making decisions related to the MW15

drums and bike frames? Why? (2 pts)

2.

Assuming direct labor is a fixed cost, compute the contribution margin

per unit for: (3 pts)

a. Purchased MW15 drums.

b. Manufactured MW15 drums.

c. Manufactured bike frames.

3.

Assuming direct labor is a fixed cost, determine the number of MW15

drums (if any) that should be purchased and the number of MW15

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? (5 pts)

As soon as your analysis was shown to the top management team at

Metal Works, 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 Metal Works. 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 Metal Works. 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.

4.

Assuming direct labor is a variable cost, compute the contribution

margin per unit for: (3 pts)

a. Purchased MW15 drums.

b. Manufactured MW15 drums.

c. Manufactured bike frames.

5.

Assuming direct labor is a variable cost, determine the number of

MW15 drums (if any) that should be purchased and the number of

MW15 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? (5 pts)

6.

What do you think is the correct way to treat direct labor in this

situationas a variable cost or as a fixed cost? Explain. (2 pts)