10.3 Decision Making - Special Orders Flashcards
The loss of a key customer has temporarily caused a company to have some excess manufacturing capacity. They are considering the acceptance of a special order, one that involves their most popular product. Consider the following types of costs.
I. Variable costs of the product
II. Fixed costs of the product
III. Direct fixed costs associated with the order
IV. Opportunity cost of the temporarily idle capacity
Which one of the following combinations of cost types should be considered in the special order acceptance decision?
A. I and II.
B. I and IV.
C. II and III.
D. I, III, and IV.
D. I, III, and IV.
A company manufactures a variety of shoes and has received a special one-time-only order directly from a wholesaler. The company has sufficient idle capacity to accept the special order to manufacture 15,000 pairs of sneakers at a price of $7.50 per pair. The company’s normal selling price is $11.50 per pair of sneakers. Variable manufacturing costs are $5.00 per pair and fixed manufacturing costs are $3.00 a pair. The company’s variable selling expense for its normal line of sneakers is $1.00 per pair. What would the effect on the company’s operating income be if the company accepted the special order?
A. Decrease by $60,000.
B. Increase by $22,500.
C. Increase by $37,500.
D. Increase by $52,500.
C. Increase by $37,500.
The per-unit contribution margin earned from this special order will be the difference between the selling price and the company’s variable cost of manufacturing ($7.50 – $5.00 = $2.50). Variable selling expenses usually arise from commission earned by the sales staff. Since we are told that the order comes directly from the wholesaler, we can assume that no commission would be earned on the order. The net effect on operating income is therefore an increase of $37,500 (15,000 × $2.50).
A mail-order confectioner sells fine candy in one-pound boxes. It has the capacity to produce 600,000 boxes annually, but forecasts that it will produce and sell only 500,000 boxes in the coming year. The costs to manufacture and distribute the candy are detailed below. The organization has invested capital of $6,750,000.
Variable costs per pound:
Manufacturing $4.85
Packaging .35
Distribution 1.80
Total $7.00
Annual fixed costs:
Manufacturing overhead $810,000
Marketing and distribution 270,000
The confectioner has been asked by a retailer to submit a bid for a special order of 40,000 1-pound boxes of candy; this is a one-time order that will not be repeated. While the candy would be almost identical, the candy ingredients would be $0.45 less. The total distribution costs for the entire order would be $32,000. Special setup costs required by this order would amount to $60,000. There would be no other changes in costs, rates, or amounts. The minimum selling price per 1-pound box that the confectioner would bid on this special order would be
A. $9.05
B. $9.55
C. $7.05
D. $8.85
C. $7.05
The minimum selling price equals the incremental costs of the special order (variable manufacturing costs, variable packaging costs, distribution costs, and setup costs) divided by the units ordered. The fixed costs do not change because the manufacturer has excess capacity. (1) Total variable manufacturing costs are $190,000 [40,000 × ($4.85 – $.45 + $.35)], (2) distribution costs are $32,000, and (3) setup costs are $60,000. Thus, the minimum unit price is $7.05 [($190,000 + $32,000 + $60,000) ÷ $40,000].
A company manufactures a product that has the following unit price and costs.
Selling price $300
Costs
Direct materials $40
Direct labor 30
Variable manufacturing overhead 24
Fixed manufacturing overhead 60
Variable selling 6
Fixed selling and administrative 20
Total costs (180)
Operating margin $120
The company received a special order for 1,000 units of the product. The company currently has excess capacity but has an alternative use for this capacity that will result in a contribution margin of $20,000. What is the minimum price that the company should charge for this special order?
A. $120, because it covers the costs of manufacturing the product and allows the company to break even.
B. $200, because operating margin will increase by $20,000.
C. $180, because it covers the costs of manufacturing the product and allows the company to break even.
D. $140, because operating margin will increase by $20,000.
A. $120, because it covers the costs of manufacturing the product and allows the company to break even.
The minimum price that should be charged is the price at which the company is indifferent to the use of the excess capacity. When excess capacity exists, fixed costs are irrelevant and only the variable costs are considered. Under this scenario, total variable costs per unit are $100 ($40 + $30 + $24 + $6). However, the opportunity cost of the alternative also represents a relevant cost. Given an increase in contribution margin of $20,000 due to the production of 1,000 units, the per-unit contribution margin increase is $20 ($20,000 ÷ 1,000). Thus, to be indifferent to the use of the excess capacity, a minimum price of $120 per unit should be charged ($100 + $20).
A company sells two products: Sparta and Volta. Volta is manufactured by a third party supplier, which charges the company a contractual price for each unit of Volta manufactured. A summary of revenue and costs assumptions for each product is as follows:
Sparta Volta
Planned sales units prior to promotion 100,000 20,000
Unit selling price $10 $20
Unit variable cost $3 $10
Fixed costs $500,000 $0
The company has the opportunity to spend an additional $10,000 in promotional expenditures on either Sparta or Volta, anticipating a 10% increase in unit sales volume as a result. Both product lines have idle capacity and can support the increase in unit volume. The company should spend the additional promotional expenditure on
A. Sparta, because it would generate an additional $10,000 in operating profit.
B. Volta, because it would generate an additional $10,000 in operating profit.
C. Sparta, because it would generate an additional $60,000 in operating profit.
D. Volta, because it would generate an additional $20,000 in operating profit.
C. Sparta, because it would generate an additional $60,000 in operating profit.
If the company spends the additional expenditure on Sparta, sales revenue will increase by $100,000 ($10 × 10,000 units) and variable cost will increase by $30,000 ($3 × 10,000 units). Thus, the operating profit will increase by $60,000 ($100,000 – $30,000 – $10,000). If the company spends the additional expenditure on Volta, sales revenue will increase by $40,000 ($20 × 2,000 units) and variable cost will increase by $20,000 ($10 × 2,000 units). Thus, the operating profit will increase by $10,000 ($40,000 – $20,000 – $10,000). Therefore, the company should spend the $10,000 additional expenditure on Sparta because Sparta will generate more operating profit.
When considering a special order that will enable a company to make use of currently idle capacity, which of the following costs is irrelevant?
A. Depreciation.
B. Materials.
C. Variable overhead.
D. Direct labor.
A. Depreciation.
Because depreciation is expensed whether or not the special order is accepted, it is irrelevant to the decision. Only the variable costs are relevant.
Basic Computer Company (BCC) sells its micro-computers using bid pricing. It develops bids on a full cost basis. Full cost includes estimated material, labor, variable overheads, fixed manufacturing overheads, and reasonable incremental computer assembly administrative costs, plus a 10% return on full cost.
BCC’s current cost structure, based on its normal production levels, is $500 for materials per computer and $20 per labor hour. BCC’s variable manufacturing overhead is $2 per labor hour, fixed manufacturing overhead is $3 per labor hour, and incremental administrative costs are $8 per computer assembled.
BCC has received a request from a research lab for 200 computers. Assembly and testing of each computer will require 17 labor hours. BCC believes bids in excess of $1,050 per computer are not likely to be considered. Using the full-cost criteria and desired level of return, which one of the following prices should be recommended to BCC’s management for bidding purposes?
A. $1,026.30
B. $882.00
C. $961.40
D. $874.00
A. $1,026.30
The price that BCC should bid can be calculated as follows:
Materials (given) $500.00
Direct Labor (17 hours x $20) 340.00
Variable Overhead (17 hours x $2) 34.00
Fixed Overhead (17 hours x $3) 51.00
Incremental administrative (given) 8.00
Base cost 933.00
Required Return (10%) 93.30
Total Cost 1,026.30
Fixed overhead and the 10% required return are included because BCC is using the full-cost criteria on this bid.
Production of a special order will increase gross profit when the additional revenue from the special order is greater than
A. The indirect costs of producing the order.
B. The fixed costs incurred in producing the order.
C. The direct materials and labor costs in producing the order.
D. The marginal cost of producing the order.
D. The marginal cost of producing the order.
Gross profit will increase if the incremental or marginal cost of producing the order is less than the marginal revenue. Marginal cost equals the relevant variable costs assuming fixed costs are not affected by the special order.
Production of a special order will increase gross profit when the additional revenue from the special order is greater than
A. The indirect costs of producing the order.
B. The fixed costs incurred in producing the order.
C. The direct materials and labor costs in producing the order.
D. The marginal cost of producing the order.
D. The marginal cost of producing the order.
Gross profit will increase if the incremental or marginal cost of producing the order is less than the marginal revenue. Marginal cost equals the relevant variable costs assuming fixed costs are not affected by the special order.
