Question

Negan Sports Inc. produces high quality handcrafted wooden baseball bats used by many major league players. Lucille Corp. is looking to purchase bats to use in its corporate marketing campaign and has offered to purchase 3,000 bats from Negan Sports' customised range. The typical cost of one of the bats is as follows:

Direct material

$37.00

Direct labour: 2 hours at $15.00

30.00

Total manufacturing overhead:

   2 hours at $35.00

70.00

Total

$137.00

The normal selling price of one of the bats is $180, however Lucille Corp. has offered Negan Sports $115 because of the large quantity it is willing to purchase.

Lucille Corp requires a gold embossed logo on the bats that will increase direct materials costs by $4. Negan Sports will incur an additional $8,700 in set ups costs and will need to purchase a special device for the embossing at a cost of $3,300. This device will no longer be needed once the special order is complete.

Total manufacturing overhead costs are applied to production at the rate of $35 per labour hour. This figure is based, in part, on budgeted yearly fixed overhead of $624,000 and planned production activity of 24,000 labour hours. Negan Sports’ manager believes they should allocate $5,000 of existing fixed administrative costs to the order as “part of the cost of doing business.”

Question:

Negan Sports' manager thinks they should reject the special order because “financially it’s a loser.” Do you agree with this conclusion assuming Negan Sports has excess capacity? Explain and show all calculations supporting your answer.

Overheard a fellow student in your class say, “the whole subject of differential or incremental costs is easy; variable costs are the only costs that are relevant to making special order decision.” Do you agree? Explain

Answer 1

Requirement 1:

Fixed Manufacturing Overhead Per Labor Hour = Fixed Manuf Overhead / Planned Labor Hours

= $624,000 / 24,000 hours

= $26 per Labor Hour

Variable MOH = Total MOH - Fixed MOH

= $35 - $26

= $9 per labor Hour

Incremental Sales revenue	(3,000 units @ $115)		$ 345,000
Less: Incremental Variable Cost
Direct Material		$            41
Direct Labor	(2 Hours @ $15)	$            30
Variable MOH	(2 Hours @ $9)	$            18
Variable Cost per Unit		$            89
Total Variable Cost			$ 267,000
Less: Incremental Fixed Costs
Additional Set up Cost		$      8,700
Special Device Cost		$      3,300
Total Fixed Cost			$ 12,000
Incremental benefit			$ 66,000

*No part of existing Fixed Manufacturing shall form a part of incremental cost analysis for the analysis of project as the existing Fixed Manufacturing Cost will continue irrespective of special order.

The Special Order should be accepted because it has an incremental benefit of $66,000.

Requirement 2:

The concept of Incremental Cost or differential cost is not just variable cost but it includes incremental variable cost as well as incremental fixed cost related to the order. Some special orders may change the variable cost per unit and require us to incurr some fixed cost for the fulfillment of the order. Let us take the example of the above question. The special order has increased the variable cost of the direct material per unit. Therefore, the variable cost in special offer has increased. Moreover, the special order requires gold embossed logo on the bats for which we will have to purchase a device costing $3,300 that will be useless after the special order and an additional setup cost of $8,700. These are not variable costs but are incremental fixed costs for accepting the special order. If these costs are ignored, then it may result in incorrect decision making. Therefore, we should consider all incremental variable costs as well as incremental fixed costs as relevant.