Question

Huang Automotive is presently operating at 75% of capacity. The company recently received an offer from a Korean truck manufacturer to purchase 28,500 units of a power steering system component for $190 per unit.  Peter Wu, vice-president of sales, notes that although there will be an additional $2.50 shipping cost for each component, he thinks that accepting the order will get the company's "foot in the door" of an expanding international market.

Huang's production and cost information for the last two years for the component are as follows:

	204,000 units	230,000 units
Direct material costs	$17,238,000	$19,435,000
Direct labor costs	5,202,000	5,865,000
Overhead costs	22,302,000	23,615,000
Selling and administrative costs	9,048,000	9,360,000
Total costs	$53,790,000	$58,275,000
Total costs per unit	$263.68	$253.37

T.J. Chan, vice-president of engineering, feels that any new market should first show its profitability and that the $190 per unit offer is not only below the regular $270 selling price, but it's below the unit cost of the component. She also points out that there will be additional setup costs of $225,000 and that Huang will have to lease some special equipment for $260,000.

Required
1. Using the high-low method to determine cost behavior, what would the expected profit be on the special order (use a negative sign for a loss)?

Answer 1

Answer

First we have to determine which cost is variable and which is fixed

Direct Material Cost

At 204,000 Units, Per unit Material Cost = $84.5 per unit ($17,238,000 / 204,000 Units)

At 230,000 Units, Per unit Material Cost = $84.5 per unit ($19,435,000 / 230,000 Units)

So Material Cost is same per year that means Material Cost is Variable Cost

Direct Labor Cost

At 204,000 Units, Per unit Labor Cost = $25.5 per unit ($5,202,000 / 204,000 Units)

At 230,000 Units, Per unit Labor Cost = $25.5 per unit ($5,865,000 / 230,000 Units)

So Labor Cost is same per year that means Labor Cost is also Variable Cost

Overhead Cost

At 204,000 Units, Per unit Overhead Cost = $109.32 per unit ($22,302,000  / 204,000 Units)

At 230,000 Units, Per unit Overhead Cost = $102.67 per unit ($23,615,000 / 230,000 Units)

So Overhead Cost is not same per year that means Overhead Cost is Mixed Cost.

Variable Overhead Cost = Change in Cost / Change in Units

= ($23,615,000 - 22,302,000) / (230,000 – 204,000 Units)

Variable Overhead Cost = $50.5 Per Unit

Fixed Overhead Cost = Total Cost – Variable Cost

At 204,000 Units

= $22,302,000  – (204,000 Units * $50.5 per unit)

Fixed Overhead Cost = $12,000,000

Direct Selling and Adm. Cost

At 204,000 Units, Per unit Selling and Adm. Cost = $44.35 per unit ($9,048,000/ 204,000 Units)

At 230,000 Units, Per unit Selling and Adm. Cost = $40.7 per unit ($9,360,000/ 230,000 Units)

So Selling and Adm. Cost is not same per year that means Selling and Adm. Cost is Mixed Cost.

Variable Selling and Adm. Cost = Change in Cost / Change in Units

= ($9,360,000- 9,048,000) / (230,000 – 204,000 Units)

Variable Selling and Adm. Cost = $12 Per Unit

Fixed Selling and Adm. Cost = Total Cost – Variable Cost

At 204,000 Units

= $9,048,000– (204,000 Units * $12 per unit)

Fixed Selling and Adm. Cost = $6,600,000

Now we know the Variable and Fixed Cost, which will help us determine whether we should accept this order or not.

If we will accept this order then we will only incur variable Cost, as Fixed Cost doesn’t change with change in Production or Sales.

	Cost
Sales (28,500 Units * 190)	5,415,000.00
Less: Cost
Existing Cost
Material (28,500 Units * 84.5)	2,408,250.00
Labor (28,500 Units * 25.5)	726,750.00
Variable Overhead (28,500 Units * 50.5)	1,439,250.00
Variable Selling and Adm. (28,500 Units * 12)	342,000
New Cost
Shipping Cost (28,500 Units * 2.5)	71,250.00
Setup Cost	225,000.00
Lease Cost	260,000.00
Total Cost	5,472,500.00
Net Loss	(57,500.00)

Note:

There are some new cost which we will consider in Decision Making

Conclusion

We should not accept this order as it will decrease our Net Income by $57,500

Dear Student, if u have query, plz feel free to reach me.