Margin Per Unit and Labor Cost Case Study

Required:

The company is to decide in what quantities it will manufacture (or buy) XSZX drums and Mountain bike frames.

1. The margins of the two products are provided in the report submitted by the Accounting Department. Is the report (margin per unit) useful for the decision that the company has to make? Why or why not? Does it make any sense to even consider producing the mountain bike frames? Explain.

* For requirements 2, 3, 4 and 5 below, assume that direct labor is a variable cost.

2. Compute the contribution margin per unit for:
a. Purchased XSX drums.
b. Manufactured XSX drums.
c. Manufactured mountain bike frames.

3. In making the decision (Read requirement 4 below first), are there any opportunity costs in this situation? Write your reasoning.

4. Determine (a) the number of XSX drums (if any) that should be manufactured; (b) the number of XSX drums (if any) that should be purchased; (c) the number of 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?

5. Exwelda is a company that rents welding machines. Exwelda charges its machine rental fee by the hour of welding machine time. Assume that Storage Systems is considering renting the machines. What is the highest price per hour of welding machine time that Storage Systems is willing to pay?

You were supposed to treat direct labor as a variable cost in the above requirements 2-5. Regardless of the way of treatment, read the following and answer for requirement 6.

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 textbooks 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 it? 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 just-in-time 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.

6. What do you think is the correct way to treat direct labor in this situation-as a variable cost or as a fixed cost? Why?