Question

This is a special order problem that also requires that you use the high low method to estimate some cost function parameters, so you may want to review the high-low method lectures in Module 1. As with almost all of the analyses that we have done, determining variable and fixed costs, and knowing what to do with them, is critical.
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Huang Automotive is presently operating at 75% of capacity. The company recently received an offer from a Korean truck manufacturer to purchase 28,500 units of a power steering system component for $195 per unit. Peter Wu, vice-president of sales, notes that although there will be an additional $2.25 shipping cost for each component, he thinks that accepting the order will get the company's "foot in the door" of an expanding international market.

Huang's production and cost information for the last two years for the component are as follows:

	197,000 units	220,000 units
Direct material costs	$16,055,500	$17,930,000
Direct labor costs	5,319,000	5,940,000
Overhead costs	23,320,000	24,700,000
Selling and administrative costs	9,468,500	9,710,000
Total costs	$54,163,000	$58,280,000
Total costs per unit	$274.94	$264.91

T.J. Chan, vice-president of engineering, feels that any new market should first show its profitability and that the $195 per unit offer is not only below the regular $270 selling price, but it's below the unit cost of the component. She also points out that there will be additional setup costs of $295,000 and that Huang will have to lease some special equipment for $250,000.

Required
1. Using the high-low method to determine cost behavior, what would the expected profit be on the special order (use a negative sign for a loss)?

Answer 1

Calculation of expected profit on the special order.

By using past two years data, we will find out per unit cost of Direct material, Direct labour, Fixed cost component and variable cost component in case of overheads and selling and administrative costs.

a) Direct Material Cost = $17930000/220000 units = $81.5 per unit.

b) Direct labour cost = $5940000/220000 units = $27 per unit.

c) we will use high low method to find out variable cost and fixed cost component in case of overheads.

Variable cost per unit = Difference in overheads costs/Difference in units

Variable cost per unit = $24700000-$23320000/220000 units - 197000 units

Variable cost per unit = $1380000/23000 units

Variable cost per unit = $60 per unit

Fixed cost = Total Overheads - Total Variable cost

Fixed cost = $24700000 - (220000 units * $ 60 per unit)

Fixed cost = $11500000

d) We will use high low method to find out variable cost and fixed cost component in case of Selling and administrative cost

Variable costs per unit = Difference in Selling and administartive costs/difference in units

Variable cost per unit = $9710000 - $9468500/220000 units - 197000 unit

Variable cost per unit = $241500/23000 units

Varible cost per unit = $10.5

Fixed costs = Total Selling and administrative cost - Total Variable cost

Fixed Costs = $9710000 - (220000 units * $10.5 per unit)

Fixed costs = $7400000

Calculation of expected profit

​Total Sales = 28500 units * $195 per unit = $55,57,500

Less - Direct Material = 28500 units * $81.5 per unit = $2322750

Less - Direct Labour = 28500 units * 27 per unit = $769500

Less -Variable overhead cost = 28500 units * $60 per unit = $1710000

Less - Variable selling and administrative cost = 28500 units * $10.5 per unit = $299250

Less - Cost Shipping cost = 28500 units * $2.25 per unit = $64125

Less - Additional set up cost = $295,000

Less - Leasing cost of special equipment = $250,000

Total = -153125

​The company is not earning any profit on the special order, in contrast, company is having loss on this order.