Question

Polaski Company manufactures and sells a single product called a Ret. Operating at capacity, the company can produce and sell 50,000 Rets per year. Costs associated with this level of production and sales are given below:

	Unit				Total
Direct materials	$	15			$	750,000
Direct labor		6				300,000
Variable manufacturing overhead		3				150,000
Fixed manufacturing overhead		7				350,000
Variable selling expense		4				200,000
Fixed selling expense		6				300,000
Total cost	$	41			$	2,050,000

The Rets normally sell for $46 each. Fixed manufacturing overhead is $350,000 per year within the range of 40,000 through 50,000 Rets per year.

Required:

1. Assume that due to a recession, Polaski Company expects to sell only 40,000 Rets through regular channels next year. A large retail chain has offered to purchase 10,000 Rets if Polaski is willing to accept a 16% discount off the regular price. There would be no sales commissions on this order; thus, variable selling expenses would be slashed by 75%. However, Polaski Company would have to purchase a special machine to engrave the retail chain’s name on the 10,000 units. This machine would cost $20,000. Polaski Company has no assurance that the retail chain will purchase additional units in the future. What is the financial advantage (disadvantage) of accepting the special order? (Round your intermediate calculations to 2 decimal places.)

2. Refer to the original data. Assume again that Polaski Company expects to sell only 40,000 Rets through regular channels next year. The U.S. Army would like to make a one-time-only purchase of 10,000 Rets. The Army would pay a fixed fee of $1.20 per Ret, and it would reimburse Polaski Company for all costs of production (variable and fixed) associated with the units. Because the army would pick up the Rets with its own trucks, there would be no variable selling expenses associated with this order. What is the financial advantage (disadvantage) of accepting the U.S. Army's special order?

3. Assume the same situation as described in (2) above, except that the company expects to sell 50,000 Rets through regular channels next year. Thus, accepting the U.S. Army’s order would require giving up regular sales of 10,000 Rets. Given this new information, what is the financial advantage (disadvantage) of accepting the U.S. Army's special order?

Answer 1

Polaski Company

1. Determination of the financial advantage (disadvantage) of accepting the special order:

Sales	(46-16% x46) x 10,000	$386,400
Direct materials	$15	$150,000
Direct labor	$6	$60,000
Variable overhead	$3	$30,000
variable selling overhead	$1	$10,000
Cost of new machine	$2	$20,000
Total costs		$270,000
Net financial advantage		$116,400

1. Financial advantage of sales from the US Army order:

Revenues from order for 10,000 Rets -
Cost of production reimbursed	($24 +$7 = $31	$310,000
fixed fee of $1.20		$12,000
Total revenues		$322,000
Less: incremental costs (variable production costs)		$240,000
Net increase in income		$82,000

Notes:

Variable production costs –

Direct materials + direct labor + variable manufacturing overhead = $15 + $6 + $3 = $24

Since the reimbursement for costs includes both variable and fixed costs of production, the cost of production per unit includes total variable cost of $24 plus the fixed element of $7, which equals to $31.

The order eliminates the variable selling and administration costs, hence the same are not relevant for the analysis.

	Regular o	US Army order	Increase/Decrease
Sales	$460,000	$386,400	($73,600)
Less: variable costs	$240,000	$200,000	$40,000
Net decrease in net income on acceptance of Army's order	$220,000	$186,400	$33,600

Note: Acceptance of the order from the US Army would avoid the variable selling expenses of $4 per unit. Hence the variable cost for the Army’s order is $20 x 10,000 = $200,000