Question

RELEVANT COSTS FOR DECISION MAKING

OKLAHOMA COMPANY

……… normally sells product Z for $30 per unit. Unit product costs are as follows:

Direct materials	$4
Direct labor	5
Manufacturing overhead	10
Total	$19

In addition, the standard amount of shipping cost is $.50 per unit.

A one-time special order to purchase 20,000 units was recently received at a price of $27 per unit. The company currently has capacity of 120,000 units and is currently producing 90,000, therefore, there is enough capacity to fill the order and filling this order would not disrupt current operations. They would incur an additional $2.50 per unit for shipping costs. Half of the manufacturing overhead costs are fixed and would be incurred no matter how many units are produced.

Required:

1. Should this order be accepted? How much better (or worse) off would the firm be if they accepted it?

2. In negotiating a price, the minimum acceptable selling price would be, assuming that they does not want to lose money on this job?

3. Assume that the incremental costs (relevant outlay) of producing the new units total $17 per unit, and that they are now operating at capacity, and accepting this order will displace other normal work. What is the total incremental income (or loss) associated with accepting the order?

4. Given the capacity situation, what is the minimum price (per unit) the company would have to charge in order to be able to accept the special order?

5. Assume that the company has 500 units of Product Z left in their warehouse that must be sold immediately at reduced prices, otherwise, the inventory will become worthless and will have to be thrown away. What is the minimum price that they must charge for these units?

Answer 1

1. The incremental per unit cost of this additional sale quantity is $17 which can be calculated as below:

Incremental revenue per unit is $27 which is more than incremental cost. Therefore, this order should be accepted.

By accepting this offer, company would earn: (incremental revenue - incremental cost) X number of units

: (27-17)X20,000 = $200,000

2. Minimum acceptable selling price would be equal to incremental cost per unit which is $17 as calculated above.

3. If the company is operating at capacity, and accepting this order will displace other normal work, then company will loose any cost which is spent over and above the standard costs per unit. it is mentioned that for this order, company will have to spent additional shipping cost of $2.50 per unit, therefore company will loose $50,000 (2.50 X 20,000) by accepting this order.

4. Given the capacity situation, minimum price per unit : existing selling price + additional cost per unit

: 30+2.50 = $32.50 per unit.

5. As it is mentioned that if the units are not sold immediately, it would become worthless and will have to be thrown away, there is no minimum price they must charge for these units. Therefore, answer is $0.