Question

Petro Motors Inc. (PMI) produces small gasoline-powered motors for use in lawn mowers. The company has been growing steadily over the past five years and is operating at full capacity. PMI recently completed the addition of new plant and equipment at a cost of $7,800,000, thereby increasing its manufacturing capacity to 100,000 motors annually. The addition to plant and equipment will be depreciated on a straight-line basis over 10 years.

Sales of motors were 60,000 units prior to the completion of the additional capacity. Cost records indicated that manufacturing costs had totaled $60 per motor, of which $48 per motor was considered to be variable manufacturing costs. PMI has used the volume of activity at full capacity as the basis for applying fixed manufacturing overhead. The normal selling price is $80 per motor, and PMI pays a 5% commission on the sale of its motors.

LawnPro.com offered to purchase 35,000 motors at a price of $60 per unit to test the viability of distributing lawn mower replacement motors through its website. PMI would be expected to produce the motors, store them in its warehouse, and ship individual motors to LawnPro.com customers. As orders are placed directly through the LawnPro.com website, they would be forwarded instantly to PMI. No commissions will be paid on this special sales order, and freight charges will be paid by the customer purchasing a motor.

A. Calculate the cost per motor, for cost accounting purposes, after completion of the additional plant capacity.

B. Should the offer from LawnPro.com be accepted?

C. If relevant cost analysis was not considered, is it likely that a correct special order analysis would have been made?

Answer 1

PART – A)

Total fixed cost = Units at the full capacity*(Total cost – Variable cost for each unit) + Additional rise in fixed cost

= 60,000 units*($60 – $48) + ($7,800,000/10 years)

= 60,000 units*$12 + $780,000

= $720,000 + $780,000

= $1,500,000

Fixed cost per unit = Total fixed cost/Total manufacturing units

                               = $1,500,000/100,000 motors

                               = $15 per unit

Cost per unit = Variable cost – Fixed cost

                      = $48 – $15

                      = $33

PART – B)

Contribution margin of LawnPro.com = Total cost – Variable cost

                                                              = $60 – $48

                                                              = $12 per unit

If the firm has no other choice for providing more contribution as compared to $12 or the cost doesn’t exceed by $12 per motor then offer from LawnPro.com should be accepted.

PART – C)

The correct decision cannot be made if the company doesn’t follow analysis of relevant cost. If we make normal decision for allocating fixed cost for the 35,000 units for the order then it will depend on the company to accept or avoid the order as it will cause a situation of no loss or profit.

BEP = Selling price – Full cost

        = $60 – $60

        = $0