Question

Morning Sky, Inc. (MSI), manufactures and sells computer games. The company has several product lines based on the age range of the target market. MSI sells both individual games as well as packaged sets. All games are in CD format, and some utilize accessories such as steering wheels, electronic tablets, and hand controls. To date, MSI has developed and manufactured all the CDs itself as well as the accessories and packaging for all of its products.

The gaming market has traditionally been targeted at teenagers and young adults; however, the increasing affordability of computers and the incorporation of computer activities into junior high and elementary school curriculums has led to a significant increase in sales to younger children. MSI has always included games for younger children but now wants to expand its business to capitalize on changes in the industry. The company currently has excess capacity and is investigating several possible ways to improve profitability.

MSI has been approached by a fourth-grade teacher from Portland about the possibility of creating a specially designed game that would be customized for her classroom and environment. The teacher would like an educational game to correspond to her classroom coverage of the history of the Pacific Northwest, and the state of Oregon in particular. MSI has not sold its products directly to teachers or school systems in the past, but its Marketing Department identified that possibility during a recent meeting.

The teacher has offered to buy 2,500 copies of the CD at a price of $6.00 each. MSI could easily modify one of its existing educational programs about U.S. history to accommodate the request. The modifications would cost approximately $470. A summary of the information related to production of MSI’s current history program follows:

Direct materials	$	1.17
Direct labor		0.45
Variable manufacturing overhead		2.19
Fixed manufacturing overhead		1.80
Total cost per unit	$	5.61
Sales price per unit	$	13.00

Required:
1. Compute the incremental profit (or loss) from accepting the special order.

2. Should MSI accept the special order?

3. Suppose that the special order had been to purchase 2,500 copies of the program for $2.50 each. Compute the incremental profit (or loss) from accepting the special order under this scenario.

4. Suppose that MSI is operating at full capacity. To accept the special order, it would have to reduce production of the history program. Compute the special order price at which MSI would be indifferent between accepting or rejecting the special order.

MSI is considering outsourcing the production of the handheld control module used with some of its products. The company has received a bid from Monte Legend Co. (MLC) to produce 21,000 units of the module per year for $24.00 each. The following information pertains to MSI’s production of the control modules:

Direct materials	$	13
Direct labor		6
Variable manufacturing overhead		4
Fixed manufacturing overhead		5
Total cost per unit	$	28

MSI has determined that it could eliminate all variable costs if the control modules were produced externally, but none of the fixed overhead is avoidable. At this time, MSI has no specific use in mind for the space that is currently dedicated to the control module production.

Required:
1. Compute the difference in cost between making and buying the control module.

2. Should MSI buy the modules from MLC or continue to make them?

3-a. Suppose that the MSI space currently used for the modules could be utilized by a new product line that would generate $29,000 in annual profit. Recompute the difference in cost between making and buying under this scenario.

3-b. Does this change your recommendation to MSI?

Answer 1

Question-1
1
	Per unit	Total 2500 units
Incremental revenue	6.00	15000
Incremental costs:
Direct materials	1.17	2925
Direct labor	0.45	1125
Variable manufacturing overhead	2.19	5475
Modifications cost		470
Total Incremental costs		9995
Incremental net operating income(loss)		5005
Profit(or loss) increases by 5005
2
Yes, accept the special order
3
	Per unit	Total 2500 units
Incremental revenue	2.50	6250
Incremental costs:
Direct materials	1.17	2925
Direct labor	0.45	1125
Variable manufacturing overhead	2.19	5475
Modifications cost		470
Total Incremental costs		9995
Incremental net operating income(loss)		-3745
Profit(or loss) decreases by 3745
4
Special order price	13.19	=13+(470/2500)

Question-2
1
	Per unit		Total 21000 units
	Make	Buy	Make	Buy
Direct materials	13		273000
Direct labor	6		126000
Variable manufacturing overhead	4		84000
Purchase cost		24		504000
Total			483000	504000
Difference in cost = 21000 (483000-504000)
2
Make, as cost of making is less
3a
	Make	Buy
Total cost	483000	504000
Opportunity cost	29000
Total relevant cost	512000	504000
Difference in cost = 8000 (512000-504000)
3b
Yes, now the recommendation is Buy