Question

own standard and premium labels. The company has been in business for many years and is a “household name”. Its Denver soup plant has a capacity of 120,000 cases/mo, but has been operating at a normal volume of 85,000 cases/mo. Hinds has been approached by Mondo Mart, a large discount retailer, about producing a line of soups under a Mondo Mart house label. Mondo would initially place an order for 15,000 cases/mo, with the understanding that the order will be expanded if the product is successful. The initial order would be for a reduced line of four relatively simple soups, following Hinds’ normal recipes. All of these soups have essentially the same production cost of $31 per case, as follows: ingredients and packaging, $17; direct labor, $3; overhead, $11. The overhead is 55% fixed manufacturing costs, 25% variable manufacturing costs, and 20% allocated general corporate overhead. Hinds would incur $6,000/mo additional setup costs if the order is accepted. Packaging would cost twenty cents/case less because of a cheaper label used by Mondo. Hinds normally sells these soups for $38/case. Mondo Mart has offered $29/case, arguing that the steep discount is necessary for them to price the product in conformity with their pricing philosophy and customer expectations. The regional marketing director is inclined to reject the offer, because it is below cost, and therefore Hinds will lose money on the contract. The ultimate decision is up to the regional director of operations.
Required: Discuss the factors that the operations director should consider in making the decision.

Answer 1

The operations director should consider the contribution coming in because of the new contract and not just the total overall profit. He should apply the concepts of marginal costing and evaluate the contract.

Evaluation

Particulars	Amount	Amount '000
Current Production	85000	85
	Per Unit	Total
Ingredients and Packing	17	1445
Labour	3	255
Fixed Manufacturing	6.05	514.25
Variable Cost	2.75	233.75
Allocated Corporate Cost	2.20	187
Total	31	2635
Only Variable Cost	$22.75	$1933.75

So, to evaluate the new contract, he should consider only the variable cost and any specific costs associated to the contract, as fixed costs are already being addressed by the current production.

===> The new contract's cost of production

Quantity	15000
Variable Cost	22.75
Additional Cost @$6,000	0.4
Cost	$23.15

As the cost of production for the new contract is less than the offered $29, the operational director should accept the contract.