Question

An equipment manufacturer is in the third year of a 6 year contract for ABCD corporation. The contract calls for annual production of 30,000 units at a selling price of $45 per unit. Variable costs are $25 per unit and direct fixed costs are $100,000 per year. A new customer (XYZ corporation) approaches you and asks you to produce on a one time basis (i.e. no follow up contract) 60,000 units of the same equipment at a selling price of $35. There are no incremental direct fixed costs. (a) What is the net segment income of the ABCD contract per year and over the 6 year life of the contract? (b) What is the net segment income of the XYZ contract? (c) If the contract with ABCD calls for you to reduce your selling price for the rest of the 6 year contract to that of XYZ, what is the real value of the XYZ contract?

Answer 1

Original annual profit for contract with ABCD corporation

= 30000 units x ( $45 / unit selling price - $25/ unit variable cost ) - $100,000 fixed cost

= $ 30,000 x 20 - $100,000

= $600,000 - $100,000

= $500,000

Therefore , total profit for 6 years from ABCD contract = $500,000 / year x 6 years = $3,000,000

Profit from producing 60,000 units for XYZ customer = 60,000 units x ( $35 / unit selling price - $25 / unit   variable cost ) = $600,000

Therefore , total profit for ABCD corporation over 6 years = $3,000000 + $600000 = $ 3,600000

Hence , net segmented income of ABCD contract per year = $3,600000/6 = $600,000

NET SEGMENTED INCOME OF ABCD CONTRACT PER YEAR = $500,000

NET SEGMENTED INCOME FOR ABCD CORPORATION FOR 6 YEARS = $3,000000

NET SEGMENTED INCOME OF XYZ CORPORATION = $600,000

Answer to question C :

Selling price for ABCD contract for next 3 years ( i.e. for rest of the 3 year contract) being same as that of XYZ contract ( which is at $35 ) = $35

We have been asked to find out real value of XYZ contract ( and not real value of ABCD contract).

Real value of XYZ contract = $35/ unit x 60,000 units = $2,100000