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.
A company manufactures a product that is sold for $37.95. It uses an absorption-cost system. Plant capacity is 750,000 units annually, but normal volume is 500,000 units. Costs at normal volume are given below.
Unit Cost of
Direct materials $9.80
Direct labor 4.50
Manufacturing Overhead 12.00
Selling and administrative:
Variable 2.50
Fixed 4.20
Total Cost $33.00
Fixed manufacturing overhead is budgeted at $4.5 million. A customer has offered to purchase 100,000 units at $25 each to be packaged in large cartons, not the normal individual containers. It will pick up the units in its own trucks. Thus, variable selling and administrative expenses will decrease by 60%. Which of the following is not included in the calculation of relevant costs?
A. $2,250,000.
B. $4,900,000.
C. $6,600,000.
D. $1,250,000.
C. $6,600,000.
The necessary assumptions that (1) all fixed costs and (2) the unit variable costs of direct materials, direct labor, and manufacturing overhead are not affected by the special order. Thus, fixed selling and administrative costs of $2,100,000 (500,000 unit volume x $4.20) and budgeted fixed manufacturing overhead ($4,500,000), a total of $6,600,000, are not relevant. They do not change if the order is accepted.
A corporation manufactures integrated computer components. Its unit cost structure, based upon a volume of 300,000 units, is as follows.
Direct Material
Variable Cost: $3.50
Total Cost: $3.50
Direct labor
Variable Cost: 9.00
Total Cost: 9.00
Packaging
Variable Cost: 2.00
Total Cost: 2.00
Manufacturing O/H
Variable Cost: 3.00
Fixed Cost: 6.50
Total Cost: 9.50
Marketing costs
Variable Cost: 2.50
Fixed Cost: 8.00
Total Cost: 10.50
Administrative costs
Variable Cost: 4.00
Fixed Cost: 4.50
Total Cost: 8.50
Total costs
Variable Cost: $24.00
Fixed Cost: $19.00
Total Cost: $43.00
A foreign company recently approached the corporation with an order of 50,000 units of a specially designed component at $35 per unit. The order will require specialized procurement costs of $150,000, and only one-half of the variable costs associated with the administrative area will be needed. Otherwise, cost behavior will remain the same. Adequate capacity is available to handle this request. What is the relevant unit cost to be considered by the corporation in making a decision on this offer?
A. $24.00
B. $22.00
C. $43.00
D. $25.00
D. $25.00
The current variable cost per unit must be adjusted as follows:
$24.00 Beginning value
+ 3.00 Specialized procurement costs ($150,000 ÷ 50,000 units)
– 2.00 Adjustment for one-half of the unneeded variable administrative costs
= $25.00
In April, a company with idle capacity has been contacted by a new customer to supply 100,000 units of its products for a special order at a price that is 25% below the company’s regular sales price. If accepted, the order will be completed and delivered in April. The order is identical to a committed order that will be produced in May. Which one of the following costs is relevant for the company’s decision whether to accept the special order?
A. The direct materials that were purchased earlier for a production order that was canceled.
B. The electricity to operate the machinery in April to produce the units.
C. The insurance on the machinery that will be used to produce the units.
D. The machine setup costs for the order.
B. The electricity to operate the machinery in April to produce the units.
Relevant costs include only those that vary with regard to the decision. The electricity costs would be relevant to the special order decision because they are variable and would occur only if the machines operated in April.
A company currently is using its full capacity of 25,000 machine hours to manufacture product XR-2000. A customer placed an order for the manufacture of 1,000 units of KT-6500. The customer would normally manufacture this component. However, due to a fire at its plant, the customer needs to purchase these units to continue manufacturing other products. This is a one-time special order. The following reflects unit cost data and selling prices.
KT-6500
Material: $27
Direct labor: 12
Variable Overhead: 6
Fixed Overhead: 48
Variable selling & administrative: 5
Fixed selling & administrative: 12
Normal selling price: $125
Machine hours required: 3
XR-2000
Material: $24
Direct labor: 10
Variable overhead: 5
Fixed overhead: 40
Variable selling & administrative: 4
Fixed selling & administrative: 10
Normal selling price: $105
Machine hours required: 4
What is the minimum unit price that the company should charge the customer to manufacture 1,000 units of KT-6500?
A. $96.50
B. $125.00
C. $110.00
D. $93.00
A. $96.50
The company would have to give up 3,000 machine hours to fill the customer’s special order for KT-6500 (1,000 units × 3 hours per unit). If the company devotes those hours to the special order, it would give up 750 units of XR-2000 (3,000 hours ÷ 4 units per hour). The per-unit cost of XR-2000 is $43 ($24 + $10 + $5 + $4), so the per-unit margin is $62 ($105 – $43). The margin that the firm would forgo if it accepts the order is therefore $46,500 (750 units × $62 margin per unit). Dividing the $46,500 of lost profits on the existing product by the 1,000 units of the special order produces an opportunity cost of $46.50 per unit. Adding this to the $50 of variable cost ($27 + $12 + $6 + $5) produces a minimum price of $96.50.
Foot Apparel manufactures socks. The Athletic Division sells its socks for $6 a pair to external customers. Socks have variable manufacturing costs of $2.50 per pair and fixed manufacturing costs of $1.50 per pair. The division’s total fixed manufacturing costs are $105,000 at the normal volume of 70,000 pairs. The operating range is 50,000 pairs to 100,000 pairs. The European Division has offered to buy 15,000 pairs at the full cost of $4. The Athletic Division has excess capacity and the 15,000 pairs can be produced without interfering with the current outside sales of 70,000 pairs. Should the Athletic Division accept the offer?
A. Yes, because the Athletic Division’s operating income will increase by $22,500.
B. Yes, because the order is within the operating range of the company.
C. No, because the Athletic Division’s operating income will decrease by $30,000.
D. No, because the price offered does not exceed the market price usually charged.
A. Yes, because the Athletic Division’s operating income will increase by $22,500.
Since fixed costs will not increase with the extra order, the only consideration is whether the selling price ($4) is greater than the variable costs of $2.50. Each additional unit produces a contribution margin of $1.50 per unit ($4 – $2.50). Multiplying the $1.50 contribution margin times the incremental sales of 15,000 units results in increased profits of $22,500.
Kator Co. is a manufacturer of industrial components. One of its products that is used as a subcomponent in auto manufacturing is KB-96. This product has the following financial structure per unit:
Selling price $150
Direct materials $ 20
Direct labor 15
Variable manufacturing overhead 12
Fixed manufacturing overhead 30
Shipping and handling 3
Fixed selling and administrative 10
Total costs $ 90
Kator Co. has received a special, one-time order for 1,000 KB-96 parts. Assuming Kator has excess capacity, the minimum price that is acceptable for this one-time special order is in excess of
A. $47
B. $60
C. $77
D. $50
D. $50
A company must cover the incremental costs of a special order when it has excess capacity. The incremental costs for product KB-96 are $50 ($20 direct materials + $15 direct labor + $12 variable overhead + $3 shipping and handling). The fixed costs will not change as a result of the special order, so they are not relevant. Thus, any price in excess of $50 per unit is acceptable.
Raymund, Inc., a bearings manufacturer, has the capacity to produce 7,000 bearings per month. Raymund’s income statement for an average month is as follows:
Sales (5,000 units at $20 per unit): $100,000
Variable manufacturing costs: $50,000
Variable selling costs: 15,000
= (65,000)
Contribution margin: $35,000
Fixed manufacturing costs: $16,000
Fixed selling costs: 4,000
= (20,000)
Operating income: $ 15,000
Raymund has an effective income tax rate of 40%. The company is considering two mutually exclusive options, replacing a portion of its labor intensive production process with a highly automated process, or filling a one-time special order.
Raymund currently sells its only product to a single customer. Raymund has received a one-time-only order for 2,000 units from another buyer. Sale of the special order items will not require any additional selling effort. In negotiating a price for the special order, Raymund should set the minimum per unit selling price at
A. $17
B. $13
C. $18
D. $10
D. $10
Raymund has excess capacity, so no new fixed costs have to be taken on to accept the special order. Also, since the question states that the special order items will not require an additional selling effort, we can conclude that no additional variable selling costs need to be paid. Thus, the only costs that must be covered by the special order are the variable manufacturing costs ($50,000 ÷ 5,000 units = $10 per unit).
The Robo Division, which is part of a large company, has been approached to submit a bid for a potential project for a customer. Robo Division has been informed by the customer that they will not consider bids over $8,000,000. Robo Division purchases its materials internally from the Cross Division. There would be no additional fixed costs for either the Robo or Cross Divisions. Information regarding this project is as follows:
Cross Division
Variable Costs: $1,500,000
Transfer Price: $3,700,000
Robo Division
Variable costs: $4,800,000
If Robo Division submits a bid for $8,000,000, the amount of contribution margin recognized by the Robo Division and the company, respectively, is
A. $3,200,000 and $(500,000).
B. $(500,000) and $1,700,000.
C. $(500,000) and $(2,000,000).
D. $3,200,000 and $1,700.000.
B. $(500,000) and $1,700,000.
The contribution margins for the Robo Division and the company can be calculated as follows:
Robo
Contract price: $ 8,000,000
Less: Variable costs (4,800,000)
Less: Transfer price (3,700,000)
= Contribution margin $ (500,000)
The Company
Contract price: $8,000,000
Less: Variable costs (4,800,000)
Less: Variable costs (1,500,000)
= Contribution margin $1,700,000
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 the School Board for 500 computers. Assembly and testing of each computer requires 12 labor hours. The company’s management expects heavy competition in bidding for this job. BCC believes bids in excess of $925 per computer are not likely to be considered. As this is a very large order for BCC, and could lead to other educational institution orders, management is extremely interested in submitting a bid that would win the job, but at a price high enough so that current net income will not be unfavorably impacted. Management believes this order can be absorbed within its current manufacturing facility. Which one of the following bid prices should be recommended to BCC’s management?
A. $849.20
B. $772.00
C. $764.00
D. $888.80
B. $772.00
The price that BCC should bid can be calculated as follows:
Materials (given) $500
Direct labor (12 hours x $20) 240
Variable overhead (12 hours x $2) 24
Incremental administrative (given) 8
= Total cost $772.00
The statement of income for Dimmell Co. presented below represents the operating results for the fiscal year just ended. Dimmell had sales of 1,800 tons of product during the current year. The manufacturing capacity of Dimmell’s facilities is 3,000 tons of product.
Dimmell Co.
Statement of Income
For the Year Ended December 31, Year 2
Sales $900,000
Variable costs:
Manufacturing $315,000
Selling costs 180,000
= Contribution margin 405,000
Fixed Costs:
Manufacturing $90,000
Selling 112,500
Administration 45,000
Operating income 157,500
Income taxes (40%) (63,000)
Net income 94,500
Dimmell has a potential foreign customer that has offered to buy 1,500 tons at $450 per ton. Assume that all of Dimmell’s costs would be at the same levels and rates as in Year 2. What net income would Dimmell make if it took this order and rejected some business from regular customers so as not to exceed capacity?
A. $256,500
B. $297,500
C. $211,500
D. $252,000
C. $211,500
Total sales equal $1,425,000 [(1,500 x $450) + (1,500 x $500)]. The unit variable cost of goods sold is $275 (55% of $500), and total variable cost of goods sold is $825,000 (3,000 units x $275). The contribution margin is $600,000, which equals $1,425,000 of sales minus $825,000 cost of goods sold. Operating income is $352,500, which is the contribution margin of $600,000 minus $247,500 fixed costs. Net income of $211,500 is calculated by subtracting tax from operating income [$352,500 x (1.0 - .40)].
Kator Co. is a manufacturer of industrial components. One of its products that is used as a subcomponent in auto manufacturing is KB-96. This product has the following financial structure per unit:
Selling price $150
Direct materials $20
Direct labor 15
Variable manufacturing overhead 12
Fixed manufacturing overhead 30
Shipping and handling 3
Fixed selling and administrative 10
Total costs $90
Kator Co. has received a special, one-time order for 1,000 KB-96 parts. Assume that Kator is operating at full capacity and that the contribution margin of the output that would be displaced by the special order is $10,000. Using the original data, the minimum price that is acceptable for this one-time special order is in excess of
A. $60
B. $70
C. $100
D. $87
A. $60
Given no excess capacity, the price must cover the incremental costs. The incremental costs for KB-96 equal $50 ($20 direct materials + $15 direct labor + $12 variable overhead + $3 shipping and handling). Opportunity cost is the benefit of the next best alternative use of scarce resources. Because acceptance of the special order would cause the company to forgo a contribution margin of $10,000, that amount must be reflected in the price. Hence, the minimum unit price is $60 [$50 unit incremental cost + ($10,000 lost CM / 1,000 units)].
