Question:Case study

Make or Buy; Utilization of a Constrained Resource

Drums, bins, boxes, and other containers that are used in the petroleum industry are sold by Holden Inc. One of the company's products is a heavy-duty, environmentally friendly, corrosion-resistant metal drum, called the STR 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 4,500 hours of welding time is available annually on the machine. Since each drum requires 0.6 hours of welding time, annual production is limited to 7,500 drums. At present, the welding machine is used exclusively to make the STR drums. The accounting department has provided the following financial data concerning the STR drums:

STR DRUMS

Selling price per drum .................................................................................$225.00

Cost per Drum

Direct materials ....................................................................$78.15

Direct labor ($27 per hour) .............................................$5.40

Manufacturing overhead ..................................................$6.75

Selling and administrative expense............................ ..$44.70$135.00

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Margin per Drum ..................................................................................... $ 90.00

Management believes that 9,000 STR 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 of quality products, Anderson Industries, Inc. Anderson would be able to provide up to 6,000 STR-type drums per year at a price of $207 per drum, which Holden would relabel and sell to its customers at its normal selling price.

Candace Burke, Holden's production manager, has suggested that the company could make better use of the welding machine by manufacturing wrought iron park benches, which would require 0.75 hours of welding time per bench and yet sell for far more than the drums. Candace believes that Holden could sell up to 2,400 wrought iron park benches per year to municipalities

and conservation areas at a price of $360 each. The Accounting Department has provided the following data concerning the proposed new product:

Wrought Iron Park Benches

Selling price per bench .......................................................................................$360.00

Cost per bench:

Direct materials ...................................................................$149.10

Direct labor ($27 per hour)......................................... .....$43.20

Manufacturing overhead............................................ ......$54.00

Selling and administrative expense ..............................$71.70$318.00

...................

Margin per bench ...................................................................................... $42.00

The park benches 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 $2.00 per STR drum and $2.85 per park bench. 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 $1.15 per STR drum whether made or purchased and would be $1.95 per park bench.

All of the company's employeesdirect and indirectare paid for full 40-hour workweeks and the company has a policy of laying off workers only in major recessions.

The park benches 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 $2.00 per STR drum and $2.85 per park bench. 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 $1.15 per STR drum whether made or purchased and would be $1.95 per park bench.

All of the company's employeesdirect and indirectare paid for full 40-hour workweeks and the company has a policy of laying off workers only in major recessions.

Required:

1.Should the financial analysis prepared by the company be used in deciding which product to sell? Why?

2.Compute the contribution margin per unit for

a.Purchased STR drums.

b.Manufactured STR drums.

c.Manufactured park benches.

3.Determine the number of STR drums (if any) that should be purchased and the number of STR drums and/or park benches (if any) that should be manufactured. What is the increase in operating income that would result from this plan over current operations?

As soon as your analysis was shown to the top management team at Holden, 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 Holden. 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 Holden. 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 just-in-time techniques. Whether the welding machine is used to make drums or park benches, 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 park benches 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 analysis treating it as a variable cost.

5.What do you think is the correct way to treat direct labor cost in this situationas variable or as fixed?