Question

The Melrose Corporation produces a single product, Product C. Melrose has the capacity to produce 94,000 units of Product C each year. If Melrose produces at capacity, the per unit costs to produce and sell one unit of Product C are as follows:

Direct materials	$	28.40
Direct labor	$	21.80
Variable manufacturing overhead	$	16.60
Fixed manufacturing overhead	$	20.00
Variable selling expense	$	14.40
Fixed selling expense	$	9.20

The regular selling price of one unit of Product C is $126.40. A special order has been received by Melrose from Moore Corporation to purchase 7,500 units of Product C during the upcoming year. If this special order is accepted, the variable selling expense will be reduced by 75%. Total fixed manufacturing overhead and fixed selling expenses would be unaffected except that Melrose will need to purchase a specialized machine to engrave the Moore name on each unit of product C in the special order. The machine will cost $8,700 and will have no use after the special order is filled. Assume that direct labor is a variable cost.

Assume Melrose expects to sell 84,000 units of Product C to regular customers next year. If Moore company offers to buy the 7,500 special units at $116.40 per unit, the effect of accepting the special order on Melrose's net operating income for next year will be:

rev: 11_01_2016_QC_CS-68232

Answer 1

Solution:

Melrose Corporation has the idle capacity which can be utilize to make special order without incurring the additional fixed cost.

In this type of question, the relevant cost is considered for decision making.

Relevant Cost is the cost which will be incurred in future and different under each alternative course of action. The following costs are considered as relevant cost:

- Direct material cost

- Direct labor cost

- Variable manufacturing overhead

- Variable Cost of Goods Sold

- Variable selling and administrative expenses

- Fixed Cost which is directly related to the alternative course of action.

The above costs are the variable cost which will vary with the production volume. Hence these costs have both the characteristic of relevant cost i.e. it is a future cost and different under each alternative course of action.

Sometimes there are some fixed costs which will directly associated with the production or increase production units and have characteristics of relevant cost. i.e. future cost and different under each alternative course of action.

Irrelevant cost is the costs which do not play any role in decision making. Irrelevant Cost is the SUNK Cost which has already been incurred and does not change whether company accept or reject the order. Hence it is treated as IRRELEVANT COST.

Note – Fixed manufacturing and selling costs are not considered relevant because these are fixed and not for the specific job. In decision making fixed costs are treated as period cost and not taken for decision making. Fixed Costs are irrelevant cost for decision making.

In this question, company has idle capacity so the only expense they will incur in producing the special order is Relevant Cost.

Calculation of Relevant Cost to be incurred by the company related to special order:

	$$
Direct materials	28.40
Direct labor	21.80
Variable manufacturing overhead	16.60
Variable selling expense ($14.40 - 75% reduced 14.4*75%)	3.60
Relevant Cost per Unit	70.40
Special Order units	7,500 Units
Total Relevant Cost (7500*70.40)	$528,000
Plus: Machine Cost directly related to special order	$8,700
Total Relevant Cost to be incurred with respect to Special Order	$536,700

Effect on Net Operating Income by accepting Special Order

	$$
Sales Revenue (7500 Units @ $116.40)	$873,000
Less: Total Revelant Cost	$536,700
Net Income from Special Order	$336,300

If the special order is accepted, the net operating income for next year will be increase by $336,300

Hope the above calculations, working and explanations are clear to you and help you in understanding the concept of question.... please rate my answer...in case any doubt, post a comment and I will try to resolve the doubt ASAP…thank you