Question

Andretti Company has a single product called a Dak. The company normally produces and sells 83,000 Daks each year at a selling price of $58 per unit. The company’s unit costs at this level of activity are given below:

Direct materials	$	7.50
Direct labor		10.00
Variable manufacturing overhead		2.20
Fixed manufacturing overhead		9.00	($747,000 total)
Variable selling expenses		2.70
Fixed selling expenses		3.00	($249,000 total)
Total cost per unit	$	34.40

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 116,200 Daks each year without any increase in fixed manufacturing overhead costs. The company could increase its unit sales by 40% above the present 83,000 units each year if it were willing to increase the fixed selling expenses by $150,000. What is the financial advantage (disadvantage) of investing an additional $150,000 in fixed selling expenses?

1-b. Would the additional investment be justified?

2. Assume again that Andretti Company has sufficient capacity to produce 116,200 Daks each year. A customer in a foreign market wants to purchase 33,200 Daks. If Andretti accepts this order it would have to pay import duties on the Daks of $3.70 per unit and an additional $26,560 for permits and licenses. The only selling costs that would be associated with the order would be $2.10 per unit shipping cost. What is the break-even price per unit on this order?

3. The company has 500 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 40% 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 83,000 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

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 40% from 83,000 units to reach 116,200 units

Fixed manufacturing overheads remain same

Selling administrative overheads increase $150,000

Calculation of contribution margin –

Contribution margin = unit sales price – unit variable cost

Unit sales price =$58

Unit variable cost –

Direct materials$7.50

Direct labor$10.00

Variable manufacturing overhead $2.20

Variable selling overhead$2.70

Contribution margin = $58 - $22.40 = $35.60

Determination of additional net income from sale of additional units –

Additional units = 33,200 (83,000 x 40%)

Additional contribution = $35.60 x 33,200 = $1,181,920

Additional selling expenses$150,000

Additional income$1,031,920

Hence, the financial advantage of investing an additional $150,000 in fixed selling expenses to produce and sell additional 40% units (33,200) each year is increase in net income by $1,031,920.

1-b.Since the company has enough capacity to produce 116,200 Daks the increase in production and sales by 40% 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 $150,000 to produce additional 40% units of Daks.

1. Evaluation of special order:

Given information –

            Number of units          33,200

Additional variable cost –

Import duty     $3.70

So, revised variable cost per unit –

Direct material            $7.50

Direct labor                 $10.00

VMOH                        $2.20

Selling OH                  $2.10

Import duty                 $3.70

Total variable cost per unit      $25.50

Additional fixed cost for permits and licenses $26,560

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 = $33,200x

Total costs = ($ 25.50 x 33,200) + $26,560

                        = $846,600 + $26,560 = $873,160

Hence, $33,200 x = $873,160

So, x = 873,160/33,200 = $26.30

The break-even price per unit for the special order is $26.30

1. Determination of the unit cost figure that is relevant for setting the minimum price for the 500 daks to be sold as ‘seconds’:

The relevant unit cost is the variable selling price - $2.70

Since the 500 Daks are already produced, the variable production costs are sunk costs and no more relevant.

The fixed costs are also sunk costs.

Since the 500 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 - $2.70

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

Two months production = 83,000 x 2/12 = 13,833 units

25% production in two months = 13,833 x25% = 3,458 units

Contribution lost when plant is closed for two months = 3,458 x $35.60 = $123,105

Since the company would incur 40% of fixed manufacturing cost, despite closing down of the plant,

The fixed manufacturing cost, the company would avoid is 60% 60% of ($747,000 x 2/12) =$74,700

The fixed selling and administrative costs is reduced by 20% = 20% of ($249,000 x2/12) =$8,300

Total fixed costs the company would avoid by closing the plant for two months = $74,700 + $8,300 = $83,000

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

Contribution margin lost if plant is closed = 35.60 x 3,458 units = $123,105

Contribution foregone= ($123,105)

Fixed costs avoided= $83,000

Disadvantage of closing the plant = excess contribution lost over avoidable fixed cost

= ($40,105)

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

25% production for two month period-

Annual normal production = 83,000 units

Monthly production = 83,000/12 = 6,917 units

Two months normal production = 2 x 6,917 = 13,833 units

25% production for two months = 13,833 x 25% = 3,458 units

Contribution from 25% production = $35.60 x 3,458 units =$123,105

Total fixed cost –

Fixed manufacturing overhead$747,000 x 2/12 = $124,500

Fixed selling overhead$249,000 x 2/12 = $41,500

Total fixed costs for two months= 124,500 + 41,500 = $166,000

Net profit/(Loss)($42,895)

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

= ($42,895) – ($40,105) = ($2,790)

Since the relative loss on closing the plant is lower and production at 25% results in net loss of $42,895 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 83,000

Avoidable variable costs –

Direct materials cost$7.50

Direct labor cost$10.00

Variable MOH$2.20

Variable S&A OH$0.90 ($2.70 x 1/3)

Total avoidable variable cost

Add: Avoidable fixed cost (30% of $747,000)/83,000 =$2.70

Total avoidable cost = $20.60 + 2.70 = $23.30

Avoidable cost per unit =$23.30

Hence, Andretti should accept a price that is less than the $23.30 per Dak from an outside manufacturer.