San Fran Ironworks Company, Inc. Case -
San Fran Ironworks manufactures a wide range of industrial valves, fittings, containers, and tools sold primarily to customers in the United States. The company is operating at 80% of capacity and is earning a satisfactory return on investment. Manufacturing valves requires a highly skilled labor force and it takes about a year to train each craftsperson. Labor, over the short-term, is a fixed production constraint. Direct labor cost averages $20 per DLH. The companies' products also require the use of computerized machines. For 2012, the company expects to have 40,000 hours of available machine time. Each valve requires 8.0 hours of machine time. This limits the company to producing 5,000 valves per year. The accounting department has provided the following financial data concerning the valves:
Industrial Valves
Selling price per valve $2,980.00
Cost per valve:
Direct materials $1,042.00
Direct labor ($20 per DLH) 72.00
Factory overhead 90.00
Selling and administrative expense 596.00 1,800.00
Margin per valve $ 1,180.00
Management believes that it could sell 6,000 valves each year if the company had sufficient machine time. As an alternative to buying and installing more machines, management has considered buying additional valves from Yung Son Manufacturing Company of Shanghai, China. Up to 4,000 valves per year could be built to San Fran's specifications and delivered to their warehouse at a total cost of $2,705.00 per valve. The valves would then be repainted at a cost of $55.00 per valve and sold to San Fran's customers at its normal selling price.
Nick Wingfield, San Fran's production manager, has suggested that the company could make better use of its computerized machine time by manufacturing certain hazardous material containers that would require 10 hours of machine time per container and sell for far more than the valve. Nick believes that San Fran could sell up to 1,600 containers per year at a price of $4,780 each. The accounting department has provided the following data concerning the proposed new product:
Hazardous Material Containers
Selling price per container $ 4,780.00
Cost per container:
Direct materials $1,988.00
Direct labor ($20 per DLH) 576.00
Factory overhead 720.00
Selling and administrative expense 956.00 4,240.00
Margin per container $ 540.00
The hazardous material containers could be produced with existing equipment and personnel. Factory overhead is allocated to products based on direct labor hours. The variable factory overhead has been estimated at $27.00 per valve and $38.00 per container. The variable factory overhead cost would not be incurred on valves 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 $15.00 per valve whether made or purchased and $26.00 per container.
All of the companies employees, direct and indirect, are paid for full 40-hour work weeks and the company has a policy of only laying off workers in a major recession.
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 the producing the containers? Explain in detail.
2. Compute the contribution margin per unit for:
a. Purchased valves.
b. Manufactured valves.
c. Manufactured hazardous waste containers.
3. Determine the number of valves (if any) that should be purchased and the number of valves and/or containers that should be manufactured. What is the increase in net operating income that would result from this plan over current operations?
4. Should direct labor be treated as a variable or fixed cost? Explain in detail.
5. Re-compute #2 and #3 making the opposite assumption about direct labor from the one you originally made. If you originally treated direct labor as a variable cost, treat it now as a fixed cost and vice versa.
6. Compare the results from #2, #3, and #5. In this particular case, how should San Fran treat direct labor cost - fixed or variable? Explain in detail.
7. Explain why traditional cost accounting sometimes leads managers to make incorrect decisions. Answer fully.