Question

Delta Company produces a single product. The cost of producing and selling a single unit of this product at the company’s normal activity level of 98,400 units per year is:

Direct materials	$	2.50
Direct labor	$	3.00
Variable manufacturing overhead	$	1.00
Fixed manufacturing overhead	$	4.45
Variable selling and administrative expenses	$	1.30
Fixed selling and administrative expenses	$	2.00

The normal selling price is $18.00 per unit. The company’s capacity is 128,400 units per year. An order has been received from a mail-order house for 2,500 units at a special price of $15.00 per unit. This order would not affect regular sales or the company’s total fixed costs.

Required:

1. What is the financial advantage (disadvantage) of accepting the special order?

2. As a separate matter from the special order, assume the company’s inventory includes 1,000 units of this product that were produced last year and that are inferior to the current model. The units must be sold through regular channels at reduced prices. The company does not expect the selling of these inferior units to have any effect on the sales of its current model. What unit cost is relevant for establishing a minimum selling price for these units?

Answer 1

1. What is the financial advantage (disadvantage) of accepting the special order?

Answer:

Financial advantage

18,000

Calculation

To calculate the financial advantage/disadvantage, as we need to consider the order for 2,500 units, we need to take each of per unit cost and find how much will incur for the production. The incremental costs are direct material cost, direct labor cost, variable manufacturing overhead, and Variable selling and administrative costs. These need to be mutiplied with 2500 units to get the total costs. The even if accept the offer for 2500 units or not, the firm will incur the fixed costs, so it is not considered.

As the special price is $15, the sales will be happening at that price for 2500 units. So the total sales amount will be 2,500 * 15 = 37,500. The total incremental costs need to be deducted from the total incremental sales to get the financial advantage.

The computation is as follows:

		2,500
	Per Unit	Units
Incremental sales (a)	15.00	37,500
Incremental costs:
Direct materials	2.50	6,250
Direct labor	3.00	7,500
Variable manufacturing overhead	1.00	2,500
Variable selling and administrative	1.30	3,250
Total incremental costs (b)	7.80	19,500
Financial advantage of accepting the special order (a) - (b)	7.20	18,000

2. As a separate matter from the special order, assume the company’s inventory includes 1,000 units of this product that were produced last year and that are inferior to the current model. The units must be sold through regular channels at reduced prices. The company does not expect the selling of these inferior units to have any effect on the sales of its current model. What unit cost is relevant for establishing a minimum selling price for these units?

Answer:

Relevant cost per unit

1.30

Explanation

The variable and administrative expenses of $1.30 is the relevant cost. As the units are already produced, the rest of variable costs become sunk cost. Also, the fixed costs cannot be changed for the price for the residue, so the fixed costs are also not considered. Hence we could consider the variable and administrative expenses of $1.30 as the relevant cost.