Question

a) ABC Inc. wishes to enter a highly competitive market, and studies have determined that products in this industry nearly all sell for $20 per unit. ABC estimates that it can produce and sell 500,000 units annually. ABC uses operating assets valued $40 million and desires a return on these assets of 15%. Calculate ABC's target cost based on the information provided.

b) ADL company produces a single component with variable and fixed production costs of $7 and $3. The product currently sells for $12 per unit. The company is currently operating at 50% of its 10,000 unit annual production capacity. A customer recently approached the company with a one-time special order for 7,000 units, offering the company only $10 per unit. Because of the specific nature of this order, the company would have to invest in a special machine (which would cost an additional $10,000) to satisfy this order. Variable production costs would remain unchanged. If the special order was accepted, the machine would be sold immediately after the order was delivered for $2,000. Should the company accept the special order? Multiple Choice:

• Yes, as the company would earn an additional $3,000.

• Yes, as the company would earn an additional $4,000.

• No, as the company would lose $15,000.

• No, as the company would lose $7,000.

c) Fixed costs are always irrelevant. TRUE or FALSE

Answer 1

a)

Operating assets value = $40 million

Targeted return = 15% x $40 million = $6 million

No. of units that can be sold = 500,000 units

Targeted profit = $12

Selling price =$20

Targeted cost = Selling price - Targeted profit = $20 - $12 = $8

b)

Answer:- Yes, as the company would earn an additional $13,000

Reason:- Fixed cost of $3 per unit is irrelevant in this case, as it is a sunk cost (ie. will be payable irrespective of decision)

Variable cost for special order = $7 x 7,000 units = $49,000

Net cost for purchase of new machine = $10,000 - $2,000 = $8,000

Total cost = $49,000 + $8,000 = $57,000

Total receipt = $10 x 7,000 units = $70,000

Profit = $70,000 - $57,000 = $13,000

c)

False, fixed costs are not always irrelevant. Fixed costs are relevant when plant is working at 100% capacity, in which case the company will have to incur further fixed costs just for the new proposal. Fixed costs are only irrelevant when they are sunk cost. Sunk cost means you have to pay the expense irrespective of your decision on new proposal.