Question

Steve Murningham, manager of an electronics division, was considering an offer by Pat Sellers, manager of a sister division. Pat's division was operating below capacity and had just been given an opportunity to produce 8,000 units of one of its products for a customer in a market not normally served. The opportunity involves a product that uses an electrical component produced by Steve's division. Each unit that Pat's division produces requires two of the components. However, the price that the customer is willing to pay is well below the price that is usually charged; to make a reasonable profit on the order, Pat needs a price concession from Steve's division. Pat had offered to pay full manufacturing cost for the parts. So Steve would know that everything was above board, Pat supplied the following unit cost and price information concerning the special order, excluding the cost of the electrical component:

Selling price            $32

Less costs:

Direct materials        17

Direct labour              7

Variable overhead     2

Fixed overhead           3

Operating profit        $3

The normal selling price of the electrical component is $2.30 per unit. Its full manufacturing cost is $1.85 ($1.05 variable and $0.80 fixed). Pat argued that paying $2.30 per component would wipe out the operating profit and result in her division showing a loss. Steve was interested in the offer because his division was also operating below capacity (the order would not use all the excess capacity).

Required:

1. Should Steve accept the order at a selling price of $1.85 per unit? By how much will his division's profits be changed if the order is accepted? By how much will the profits of Pat's division change if Steve agrees to supply the part at full cost?

2. Suppose that Steve offers to supply the component at $2. In offering this price, Steve says that it is a firm offer, not subject to negotiation. Should Pat accept this price and produce the special order? If Pat accepts the price, what is the change in profits for Steve's division?

3. Assume that Steve's division is operating at flail capacity and that Steve refuses to 'supply the part for less than the full price. Should Pat still accept the special order? Explain.

Answer 1

1

If Steve agrees to sell at $2.3 per unit, Pat's loss will be:

Operating profit @ $ 3 per unit = 8,000 units x $3

$         24,000

Less : Cost of components from Steve:

Number of components required = 8,000x2 = 16,000

Cost of 16,000 components @ $2.3 per unit

$         36,800

Loss to Pat

$       -12,800

If Steve agrees to sell at a full cost of $1.85 per unit, Pat's loss will be:

Operating profit @ $ 3 per unit = 8,000 units x $3

$         24,000

Less : Cost of components from Steve:

Number of components required = 8,000x2 = 16,000

Cost of 16,000 components @ $1.85 per unit

$         29,600

Loss to Pat

$         -5,600

If Steve agrees to sell at a full cost of $1.85, then it will reduce Pat's loss from $12,800 to $ 5,600 as shown above.

2

If Steve agrees to sell at a full cost of $2 per unit, Pat's loss will be:

Operating profit @ $ 3 per unit = 8,000 units x $3

$         24,000

Less : Cost of components from Steve:

Number of components required = 8,000x2 = 16,000

Cost of 16,000 components @ $2 per unit

$         32,000

Loss to Pat

$         -8,000

If Pat' agrees to buy from Steve at $2, he will incur a loss of $8,000. So he should not accept.

Calculation of profit for Steve at $2.3 per unit:

Normal selling price

$       2.30

Total cost

$     -1.85

Profit

$       0.45

Calculation of profit for Steve at $2 per unit:

Normal selling price

$       2.00

Total cost

$     -1.85

Profit

$       0.15

If Steve charges lower selling price of $2, it will reduce his profit by $0.30.

3

If Steve is operating at full capacity, he would not sell at lower than the current normal selling price.

In such a case, Pat would incur a loss of $12,800 as shown in part 1 of the answer above.