Question

Andretti Company has a single product called a Dak. The company normally produces and sells 90,000 Daks each year at a selling price of $54 per unit. The company’s unit costs at this level of activity are given below:

Direct materials	$	7.50
Direct labor		9.00
Variable manufacturing overhead		2.90
Fixed manufacturing overhead		10.00	($900,000 total)
Variable selling expenses		4.70
Fixed selling expenses		2.50	($225,000 total)
Total cost per unit	$	36.60

A number of questions relating to the production and sale of Daks follow. Each question is independent.

Required:

1-a. Assume that Andretti Company has sufficient capacity to produce 112,500 Daks each year without any increase in fixed manufacturing overhead costs. The company could increase its unit sales by 25% above the present 90,000 units each year if it were willing to increase the fixed selling expenses by $100,000. What is the financial advantage (disadvantage) of investing an additional $100,000 in fixed selling expenses?

1-b. Would the additional investment be justified?

2. Assume again that Andretti Company has sufficient capacity to produce 112,500 Daks each year. A customer in a foreign market wants to purchase 22,500 Daks. If Andretti accepts this order it would have to pay import duties on the Daks of $4.70 per unit and an additional $15,750 for permits and licenses. The only selling costs that would be associated with the order would be $2.60 per unit shipping cost. What is the break-even price per unit on this order?

3. The company has 900 Daks on hand that have some irregularities and are therefore considered to be "seconds." Due to the irregularities, it will be impossible to sell these units at the normal price through regular distribution channels. What is the unit cost figure that is relevant for setting a minimum selling price?

4. Due to a strike in its supplier’s plant, Andretti Company is unable to purchase more material for the production of Daks. The strike is expected to last for two months. Andretti Company has enough material on hand to operate at 25% of normal levels for the two-month period. As an alternative, Andretti could close its plant down entirely for the two months. If the plant were closed, fixed manufacturing overhead costs would continue at 30% of their normal level during the two-month period and the fixed selling expenses would be reduced by 20% during the two-month period.

a. How much total contribution margin will Andretti forgo if it closes the plant for two months?

b. How much total fixed cost will the company avoid if it closes the plant for two months?

c. What is the financial advantage (disadvantage) of closing the plant for the two-month period?

d. Should Andretti close the plant for two months?

5. An outside manufacturer has offered to produce 90,000 Daks and ship them directly to Andretti’s customers. If Andretti Company accepts this offer, the facilities that it uses to produce Daks would be idle; however, fixed manufacturing overhead costs would be reduced by 30%. Because the outside manufacturer would pay for all shipping costs, the variable selling expenses would be only two-thirds of their present amount. What is Andretti’s avoidable cost per unit that it should compare to the price quoted by the outside manufacturer?

Answer 1

Solution

Andretti Company

1. Determination of the financial advantage or disadvantage of investing an additional $150,000 in fixed selling expenses:

Assumptions –

Increase in unit sales by 25% from 90,000 units to reach 112,500 units

Fixed manufacturing overheads remain same

Selling administrative overheads increase $100,000

Calculation of contribution margin –

Contribution margin = unit sales price – unit variable cost

Unit sales price =$54

Unit variable cost –

Direct materials                             $7.50

Direct labor                                   $9.00

Variable manufacturing overhead $2.90

Variable selling overhead              $4.70

Total                                              $24.10

Contribution margin = $54 - $24.10 = $29.90

Determination of additional net income from sale of additional units –

Additional units = 22,500 (90,000 x 25%)

Additional contribution = $29.90 x 22,500 = $672,750

Additional selling expenses                      $100,000

Additional income                                    $572,750

Hence, the financial advantage of investing an additional $100,000 in fixed selling expenses to produce and sell additional 25% units (22,500) each year is increase in net income by $572,750.

1-b.Since the company has enough capacity to produce 112,500 Daks the increase in production and sales by 25% allows the company to fully absorb the fixed manufacturing overhead and selling and administration overhead.

Hence, the company is justified to make the additional investment of $100,000 to produce additional 25% units of Daks.

1. Evaluation of special order:

Given information –

            Number of units          22,500

Additional variable cost –

Import duty     $4.70

So, revised variable cost per unit –

Direct material            $7.50

Direct labor                 $9.00

VMOH                        $2.90

Selling OH                  $2.60

Import duty                 $4.70

Total variable cost per unit      $26.70

Additional fixed cost for permits and licenses $15,750

Break-even price per unit for the order,

At break-even, total revenues = total costs

Let the break-even price per unit be $x,

Revenues = $22,500x

Total costs = ($ 26.70 x 22,500) + $15,750

                        = $600,750 + $15,750 = $616,500

Hence, $22,500 x = $616,500

So, x = $616,500/22,500 = $27.40

The break-even price per unit for the special order is $27.40

2. Determination of the unit cost figure that is relevant for setting the minimum price for the 900 daks to be sold as ‘seconds’:

The relevant unit cost is the variable selling price - $4.70

Since the 900 Daks are already produced, the variable production costs are sunk costs and no more relevant.

The fixed costs are also sunk costs.

Since the 900 Daks are not to be sold through regular channels, the relevant unit cost figure for the determination of the minimum selling price is the variable selling expenses - $4.70

4.a Determination of the amount of contribution margin that Andretti has to forego if it closes the plant for two months:

when plant is closed for two months, the contribution margin for the two months production is lost.

Two months production = 90,000 x 2/12 = 15,000 units

25% production in two months = 15,000 x25% = 3,750 units

Contribution lost when plant is closed for two months = 3,750 x $29.90 = $112,125

4.b determination of the fixed cost, which the company would avoid if the plant is closed for two months:

Since the company would incur 30% of fixed manufacturing cost, despite closing down of the plant,

The fixed manufacturing cost, the company would avoid is 70%           70% of ($900,000 x 2/12) =$105,000

The fixed selling and administrative costs is reduced by 20% = 20% of ($225,000 x2/12) =$7,500

Total fixed costs the company would avoid by closing the plant for two months = $105,000 + $7,500 = $112,500

4.c financial advantage or disadvantage of closing the plant for two months –

Contribution margin lost if plant is closed = $29.90 x 3,750 units = $112,125

Contribution foregone     = ($112,125)

Fixed costs avoided         = $112,500

Advantage of closing the plant = avoidable fixed cost less contribution lost = $375

                             

4d. assuming the company operates the plant for two months –

25% production for two month period-

Annual normal production = 90,000 units

Monthly production = 90,000/12 = 7,500 units

Two months normal production = 2 x 7,500 = 15,000 units

25% production for two months = 15,000 x 25% = 3,750 units

Contribution from 25% production = $29.90 x 3,750 units =$112,125

Total fixed cost –

Fixed manufacturing overhead     $900,000 x 2/12 = $150,000

Fixed selling overhead                  $225,000 x 2/12 = $37,500

Total fixed costs for two months = 150,000 + 37,500 = $187,500

Net profit/(Loss)                                                                           ($75,375)

Comparison of the net loss from continuing production with the net disadvantage of closing the plant for two months,

= ($75,375) – 375 = ($75,750)

Since the relative profit on closing the plant is $375 and production at 25% results in net loss of $75,375 the recommendation is to close the plant.

5a Determination of Andretti’s avoidable cost per unit that it should compare to the price quoted by the outside manufacturer:

      Number of units offered to produce 90,000

Avoidable variable costs –

Direct materials cost         $7.50

Direct labor cost                $9.00

Variable MOH                  $2.90

Variable S&A OH            $1.57 ($4.70 x 1/3)

Total                                  $20.97

Total avoidable variable cost       

Add: Avoidable fixed cost (30% of $900,000)/90,000 =$3.00

Total avoidable cost = $20.97 + 3.00 = $23.97

Avoidable cost per unit =$23.97

Hence, Andretti should accept a price that is less than the $23.97 per Dak from an outside manufacturer.