Question

A fire recently destroyed a substantial portion of Culver Company’s production capacity. It will be many months before capacity can be restored. During this period, demand for the firm’s products will exceed the company’s ability to produce them. Per-unit data on the firm’s three major products is summarized as follows:

Product		A		B		C
Selling price		$74		$90		$63
Variable costs		32		25		19
Fixed costs		15		19		9
Operating profit		$27		$46		$35

Fixed costs have been allocated to the products on the basis of the labour hours required to produce each product. The major capacity constraint is the availability of time on a processing machine. Each unit of Product A and Product C requires 2 hours of processing on the machine, whereas Product B requires 3 hours.

a) Assume that the firm has enough capacity to meet the demand of the two products you identified in previous part. If estimated demand for the next product to be produced exceeds capacity by 950 units, what is the maximum amount the firm would be willing to pay to increase capacity?

b) Management adopted your plan from first part. Shortly thereafter, a strategically important customer requested that the firm supply 500 units of Product D, which has been discontinued but could be produced again if needed. Management wants to meet the customer’s request to maintain goodwill but wants to know the cost before making the decision. In the past, Product D sold for $43, incurred $22 in variable costs, was allocated $4 of fixed costs, and required 1.5 hours of processing on the machine. What is the opportunity cost of accepting the order?

Answer 1

Answer (a) Calculation of contribution per processing hour earned from the products:

                                                                                                                                                       (in $)

Particulars	Product A	Product B	Product C
Selling price(1)	74	90	63
Less: Variable cost (2)	32	25	19
Contribution (1)- (2) = (3)	42	65	44
Processing time per unit (4)	2	3	2
Contribution per processing hour (3)/ (4)	21	21.67	22
Ranking	III	II	I

Product C is providing the most contribution per processing hour, therefore, the firm should produce product C up to its external market demand.

Thereafter, after meeting the demand of Product C, Product B should be produced up to its external market demand, and with the remaining processing hours, product A should be produced.

Assuming that the firm has enough capacity to meet the demand of the Product B and Product C. If estimated demand for the product A to be produced exceeds capacity by 950 units, the maximum amount the firm would be willing to pay to increase capacity would be the contribution per processing hour earned from this increase in capacity, i.e.,

= 950 units * $21 = $19,950

Answer (b) Calculation of contribution per processing hour earned from the product D:

                                                                                                                                                (in $)

Particulars	Product D
Selling price(1)	43
Less: Variable cost (2)	22
Contribution (1)- (2) = (3)	12
Processing time per unit (4)	1.5
Contribution per processing hour (3)/ (4)	8

A strategically important customer requested that the firm supply 500 units of Product D, which has been discontinued but could be produced again if needed. Management wants to meet the customer’s request to maintain goodwill, then in such a case , firm has to sacrifice the contribution earned from production of product A, the opportunity cost of accepting the order would be contribution earned from production of product A.

For producing 500 units of product D, processing hour required would be 500 units*1.5 hours =750 hours

From 750 hours, 375 units (750 hours/2 hours) of product A could have been formed. Thus contribution lost would be 375 units* $42 =$15,750