Question

Heartland Watches Case

Imagine that you have just started working at Heartland Watches, a manufacturer of women's wristwatches, Following is the income statement of Heartland Watches for the last fiscal year.

Sales	40 000 000
Less: Cost of Goods Sold	22 000 000
Gross Margin	18 000 000
Less: Selling and Administrative Expenses	15 000 000
Net Income	3 000 000

Heartland Watches had manufactured 2 million watches, which had been sold to various department stores. At the start of 2017, Jodie Velasquez became the new president. She knew very little about accounting and manufacturing. Jodie has several questions, including inquiries about pricing of special orders.

A: To prepare better answers, you decide to convert the traditional income statement shown into a Contribution Format Income Statement. Total variable manufacturing cost was $18 million. Total variable selling and administrative expenses were $9 million. Prepare the revised Contribution Format Income Statement.

B: Complete the following table for Jodie, including your calculations:

	Total	Per Unit
Product Costs
Variable Costs
Gross Margin
Contribution Margin

C: Jodie says, "Near the end of 2016, I brought in a special order from Target for 100,000 watches at $16 each. I said I'd accept a flat $20,000 sales commission instead of the usual 6% of selling price, but my sister refused the order. She usually upheld a relatively rigid pricing policy, saying that it was bad business to accept orders that did not at least generate full manufacturing cost plus 80% of full manufacturing cost. That policy bothered me. We had idle capacity. The way I figured, our manufacturing costs would go up by 100,000 x $11 = $1,100,000, but our selling and administrative expenses would go up by only $20,000. That would mean additional operating income of 100,000 x ($16-$11) minus $20,000, or $500,000 minus $20,000, $480,000. That's too much money to give up just to maintain a general pricing policy. Was my analysis of the impact on operating income correct? If not, please show me the correct additional operating income."

Prepare a memo for Jodie summarizing your response. Answers must include supporting calculations.

D: After receiving the explanations offered in B and C, Jodie said, "Forget the Target order. I had an even bigger order from Lands' End. It was for 500,000 units and would have filled the plant completely. I told my sister I'd settle for no commission. There would have been no selling and administrative costs whatsoever because Lands' End would pay for the shipping and would not get any advertising allowances.

Lands' End offered $8.70 per unit. Our fixed manufacturing costs would have been spread over 2.5 million instead of 2 million units, Wouldn't it have been advantageous to accept the order? Our old fixed manufacturing costs were $2.00 per unit. The added volume would reduce the cost more than our loss on our variable costs per unit. Am I correct? What would have been the impact on total operating income if we had accepted the order?"

Prepare a memo for Jodie summarizing your response. Answers must include supporting calculations.

Answer 1

A. Contribution format of income statement

Sales 40000000

Less: variable cost

--Manufacturing cost 18000000

---Selling& admin cost 9000000 (27000000)

Contribution margin 13000000

Less: fixed Cost

---Manufacturing cost 4000000

---Selling&admin cost 6000000 (10000000)

Profit 3000000  

B.

	Total	Per Unit
Product Cost	37000000	18.5
Variable Cost	27000000	13.5
Gross Margin	3000000	1.5
Contribution Margin	13000000	6.5

C. Calculation of correct operating income

If we use idle capacity then only variable cost will be incurred. Fixed cost for this additional order will be zero. only additional fixed expenses of sale $20000 will be incurred.

selling price 20/unit

less: variable cost

Manufacturing cost

(9.00+4.5) (13.5)/unit

Contribution 6.5/unit

Gross contribution 6.5*20000= 130000

less: fixed selling exp (20000)

Addiional income 110000

D.

Offer should not be accepted because it is not covering our variable cost which is 9$/ unit