Question

Gloucester Ltd. manufactures specialized valves. For the first six months of 2002 the company reported the following operating results.

	Amount	Per unit
Sales	$4,000,000	$50.00
Cost of goods sold	3,200,000	40.00
Selling and administrative expenses	320,000	4.00
Net income	$480,000	$6.00

Fixed costs included in cost of goods sold in the period were $800,000; fixed costs included in selling and administrative expenses were $60,000.

Gloucester recently received a special order from an overseas industrial customer, Brewery Supply Industries (BIS), for 9,000 brewery valves at a price of $36.50 each. Accepting the order would increase variable selling and administrative expenses by $0.75 per unit because of additional shipping costs, but it would not increase fixed costs or any other unit variable costs.

Assume that Gloucester currently has just sufficient excess capacity to fill this one-time order which will take 6 months to fill.

Ignore income taxes.

Required

1. Moira Keating, VP Sales, wants to know how profitable this special order would be. Prepare a financial analysis of this order for Ms Keating.

2. Ms Keating has some additional questions regarding the BIS order:

1. What is the break-even selling price per unit?
2. What selling price would be required to produce a contribution margin of $6.00 per unit?

C. Identify and briefly justify what you would consider to be the two most important factors that are not directly financial and that management should consider in making its decision?

D. Ms Keating, VP Sales, is still unsure about the wisdom of accepting the BIS order. She has asked you to prepare a full report dealing with all the relevant issues and make a recommendation to her as to whether Gloucester Ltd. Should accept this order. Justify your conclusion, citing all relevant factors, quantitative and qualitative, including those that have been raised in your answers above.

Answer 1

Solution

Gloucester Ltd

1. Determination of the profitability of the special order:

special order units	9,000
Special order price	$36.50
Variable costs -
cogs	$30
s&a cost	$4
Total variable cost per unit	$34
contribution margin per unit	$2.50
incremental income	$22,500

Computations:

Number of units = 4,000,000/50 = 80,000 units

Variable cost of goods sold –

= total cogs – fixed cost

= 3,200,000 – 800,000 = $2,400,000

Cost per unit = 2,400,000/80,000 = $30

Variable selling and administration expenses –

= total S&A expenses - fixed portion

= 320,000 – 60,000 = 260,000

Variable S&A per unit = 260,000/80,000 = $3.25

Add: cost for special order = $0.75

Total variable S&A for special order = $4 per unit

Note: since the company has excess capacity, the regular sales will not be affected by accepting the special order. Also, the fixed costs are not relevant as these costs are incurred regardless of accepting the special order.

Ai. Determination of the break-even selling price per unit –

At break-even point, revenues equal costs. At this point there are no profits nor losses.

Hence, the break-even selling price per unit for the special order would be the variable cost per unit, $34 (as computed above).

When sales price per unit equals variable cost per unit there would no profit or loss and this price is the break-even selling price per unit.

Therefore, break-even selling price per unit = $34.

Aii. Determination of the selling price to produce a contribution margin of $6 per unit:

Selling price per unit = variable cost per unit + contribution margin per unit

Variable cost per unit = $34

Desired contribution margin per unit = $6

Hence, the needed selling price per unit = $34 + $6 = $40

C the two most important factors that are not directly financial and that management should consider in making its decision:

1. One important factor is the affect on regular sales. Though the company has enough capacity to meet the special order, the price at which the special order is accepted might be an issue. Regular customers would also demand such prices.