Question

Midwest Company manufactures lamps. Shop Smart, a large retail merchandiser, wants to buy 200,000 lamps from Midwest Company for $12 each. The lamp would carry Shop Smart’s name and would be sold in its stores.

Midwest Company normally sells 420,000 lamps a year at $16 each; its production capacity is a total of 450,000 units a year. Cost information for the lamps is as follows:

Production costs:

Variable production costs $6 per unit

Fixed manufacturing overhead ($2,100,000 / 420,000 units) $5 per unit

Selling and administrative expenses: Fixed ($840,000 / 420,000 units) $2 per unit

Shop Smart has indicated that the company is not interested in signing a contract for less than 200,000 lamps. Total fixed costs will not change regardless of whether the Shop Smart order is accepted.

By how much will overall Midwest Company’s net income change if the Shop Smart order is accepted?

Midwest Company net income will INCREASE by $200,000 if the order is accepted.

Midwest Company net income will INCREASE by $500,000 if the order is accepted.

Midwest Company net income will DECREASE by $500,000 if the order is accepted.

Midwest Company net income will DECREASE by $1,200,000 if the order is accepted.

Midwest Company net income will DECREASE by $200,000 if the order is accepted.

Midwest Company net income will INCREASE by $1,200,000 if the order is accepted.

Answer 1

Midwest Company manufactures lamps, Shop Smart wants to buy 200,000 lamps from Midwest Company for $12 each.

Midwest Company normally sells 420,000 lamps a year at $16 each and incurss the variable cost of $6 per unit.

So Contribution margin per unit = sales price -variable cost = $ 16 - 6 =$ 10 per unit.

Further the fixed costs are Fixed manufacturing overhead of $ 2,100,000 and Selling and administrative expenses of $ 840,000.

Accepting the new offer will not change the fixed costs , fixed cost per unit = $ 5 per unit + $ 2 per unit = $7 per unit

Here the total capacity of the Company is only of $ 450000 ,units in a year, and if the compaby wants to accept the offer it has to forgoe its original production. and the original production can only be of $ 250000 ( 450000-200000) units.

The existing situation profit for the Midwest company = 420000 units * ( Sales price - Variable cost per unit - fixed cost per unit )

The existing situation profit for Midwest company = 420000 units * ( $ 16 - $ 6 - $ 7) = 420000 * $ 3

The existing situation profit for Midwest company = $ 1,260,000.

If the offer is accepted, then the profit will be calculated as follows:

	Regular sales	New offer sale	Total
Units	250000	200000
Sales Price per unit	$16	$12
Sales	$4,000,000	$2,400,000	$6,400,000
Less: Variable cost	1500000	1200000	$2,700,000
Contribution Margin	$25,00,000	$12,00,000	$37,00,000
Less: Fixed Cost
Manufacturing overhead	$21,00,000	$0	$21,00,000
Selling & Distribution Overead	$8,40,000	$0	$8,40,000
Total Fixed Cost	$29,40,000	$0	$29,40,000
Net Profit	($440,000)	$1,200,000	$760,000

The Net profit after the offer accepted is = $ 760000.

Now the existing case profit = $ 1,260,000 and if the offer is accepted the profit = $ 760,000 , so there is a decrease in profit if the offer is accepted.

Midwest Company net income will DECREASE by $500,000 ( 1260000 - 760000 ) if the order is accepted.

Thus the Correct option is --------C i.e Midwest Company net income will DECREASE by $500,000 if the order is accepted.