Question

The Phone Company has the following costs of producing and selling a cell phone when it produces and sells 100,000 cell phones per month:

Per unit manufacturing cost

            Direct materials                                              $60.00

            Direct labor                                                     10.00

            Variable manufacturing overhead cost             35.00

            Fixed manufacturing overhead cost                 20.00

Per unit selling cost

            Variable                                                          20.00

            Fixed                                                               10.00

Note that ‘100,000’ is the denominator used to calculate fixed costs per unit. Total fixed costs do not change regardless of production/sales level.. The selling price of a cell phone is $250, unless otherwise stated in the questions below.

Each situation below is independent of the other situations. That is, when you answer one question, assume that the situations described in other questions have not occurred. When you are considering opportunities for increased sales, assume that Phone Company has enough manufacturing capacity to make these sales without incurring additional fixed costs (i.e., it has excess capacity).

1. The Phone Company is considering entering into a contract to provide SP Company with 8,000 cell phones per month, in addition to its existing business. The contract would require SP Company to pay Phone Company for total manufacturing costs for the 8,000 cell phones plus a profit of $750,000 per month. The Phone Company would incur no variable selling costs related to this contract. How much would Phone Company’s monthly operating income increase or decrease as a result of taking this contract? Assume that if Phone Company takes this contract, it does not change the fixed overhead allocation rate (that is, $20/unit) that it set at the beginning of the year.

2. The Phone Company has the opportunity to provide an organization with a one-time special order of 20,000 cell phones, in addition to its existing business. The only variable selling cost associated with this order would be shipping costs of $10.00 per cell phone, and fixed selling costs for this order (in addition to Phone Company’s existing fixed costs) would be $200,000. What selling price per unit would be required to generate $600,000 in incremental operating income from this order?

3. The Phone Company has received an offer by a contract supplier to make and ship the Phone Company’s cell phone (100,000 units) directly to the Phone Company’s customers. The Phone Company will continue to do some product design and marketing but will no longer manufacture the phones itself. If the Phone Company accepts this offer, its variable manufacturing costs would be $0 and its fixed manufacturing cost would be reduced by 75% of its current level. In addition, its variable selling cost would decrease by one-third and its fixed selling cost would not change. How much per cell phone could the Phone Company pay the contract supplier if it wants to maintain its present level of operating income?

Answer 1

1) contract to provide 8,000 units per month

SP company will provide for total manufacturing related costs (both fixed and variable component) and $750,000 per month

We see the costs involved other than manufacturing costs

Direct cost: $70 per unit ($60 direct material + $10 direct labour cost)

Selling costs: 10 per unit. The question states that no variable selling cost would be applicable that means on the fixed selling cost of 10 per unit will occur

Total cost: $80 per unit

For 8,000 units it would be $640,000 (80*8000)

Profit on the contract: $110,000 (750,000-640,000)

The company's income will increase by $110,000 per month by initiating the contract.

2)One time special order for 20,000 units

Costs involved

Direct cost: $70 per unit (60+10)

Manufacturing cost: $55 per unit (35+20)(variable manufacturing overhead+fixed manufacturing overhead)

Selling cost: $20 per unit ($10 fixed selling cost and $10 shipping cost) and $200,000

For 20,000 units total cost = 20,000*(70+55+20) + 200,000 = $3,100,000

We want an increment of $600,000 in incremental operating income so price per unit should be = ($3,100,000+$600,000)/20,000 = $185 per unit

3)

Present scenario

Total cost per unit: $155 per unit (60+10+35+20+20+10)

Selling price $250

Operating profit: $95 per unit (250-155)

Scenario if company accepts the offer

The company won't make the phones itself, hence no direct costs involved

Variable manufacturing cost goes 0 and fixed manufacturing costs will fall 75% i.e. to $5 per unit from $20

Variable selling cost will decrease by one-third, implying $40/3 per unit and fixed cost of $10 per unit

Total cost: $85/3 or $28.33 per unit

Required profit of $95 per unit

Selling price $250 per unit

Amount available to pay to the supplier = $126.67 per unit (250-95-28.33)