Question

Motor Corp. manufactures machine parts for boat engines. The CEO, James Hamilton, is considering an offer from a subcontractor who would provide 3,000 units of product AB100 for Hamilton at a price of $230,000. If Motor Corp. does not purchase these parts from the subcontractor it must produce them in-house with the following per-unit costs: Direct materials $ 40 Direct labor 25 Variable overhead 15 Allocated fixed overhead 4 In addition to the above costs, if the company produces part AB100, it would incur incremental fixed overhead costs of approximately $10,000. Required: a) What would be the impact on short-term operating income if the company were to accept the offer from the subcontractor? Show calculations to support your answer. b) What strategic factors/considerations are generally relevant to the special-order decision problem (i.e., whether a company should accept a one-time order from a customer with whom the company does not generally do business)? b

Answer 1

a).

As we could see here, the total cost of producing 3,000 units of AB100 is $ 2,62,000 whereas to purchase the same from a subcontractor costs only $ 2,30,000.

If the company is accepting the offer to purchase the material, the company will have a net savings of $32,000. ( 262,000 - 230,000) In the short run, the company would be able to save additional amount to the extend of $32,000 for each 3,000 units of AB100 purchased instead of in-house production.

b).

As mentioned in the question, the subcontractor is a new person for the company with whom the company doesn't deal with in a normal course of time. But, since the subcontractor is in a position to provide the material at a lower cost than producing it in the company, the company would be encouraged to purchase it from a new customer with whom the company doesn't deal in its normal course of business.

But, while doing so, the company need to be very cautious and need to follow certain strategies and made a wise decision for selecting the special order proposals. Managers must often decide whether to accept or reject an order that is outside the scope of normal sales. These one-time or special orders are often offered at a lower price than customers normally pay for the project or service. The decision managers must make is to accept or reject the offer.

Incremental Analysis (with Excess Capacity) – Capacity is a key factor in making the special order decision.   If a company has idle or excess capacity, it has not yet reached the limit on its resources, and therefore opportunity costs are not relevant. When a company is operating at full capacity, the limit on one or more of its resources has been reached, and making the choice to do one thing means giving up the opportunity to do something else. At full capacity, opportunity costs become relevant and should be incorporated in the analysis. In the case of a special-order, fixed costs are excluded form the incremental analysis because they will be incurred regardless of whether the company accepts the special order. In the short term, fixed costs will not change, so any price that exceeds the variable costs of filling the order will yield an incremental profit.

Qualitative Analysis – One would include all direct materials, direct labor and variable overhead in the cost calculation for the special order. In the case of excess capacity, on would leave out the fixed overhead due to it not being relevant in the cost calculation. Two important cautions should be noted when making this type of decision. First, the analysis in for one-time special orders only. Managers would not want to use incremental analysis to make long term pricing decisions because prices must cover all costs if the company is to be profitable in the long-run. Managers should also consider whether accepting the special order will impact the price that other customers are willing to pay for sales through regular channels. Second, this analysis is valid only if the company has excess, or idle, production capacity. If not, a firm would not be able to fill the special order with out canceling or deferring sales through regular channels, resulting in lost sales or an opportunity cost. It would not make sense to rent more machines or factory space, because more costs (fixed and variable) would be incurred, possibly(more than likely) making the special order unprofitable.

Incremental Analysis (without Excess Capacity) – As stated earlier one would need to incorporate the opportunity cost of limited capacity looking at this type of incremental analysis. The opportunity cost can be measured as the contribution margin that would be lost on sales made through regular channels. For example, if a unit of product sold through normal channels at $9 and variable costs were $5, then the contribution margin would be $4. When we apply incremental analysis without excess capacity, we would lose this $4 in contribution margin due to replacing production and sales of this product with the special order. We need to put the $4 lost in the incremental analysis as opportunity cost, which could affect whether the special order would be profitable. Many times, a special order is not profitable which this type of incremental analysis is applied.