Question

Jasper McKnight Sunglasses sell for about $150 per pair. Suppose the company incurs the following average costs per pair:
Direct materials ...................................................................................... $40
Direct labor .............................................................................................. 12
Variable manufacturing overhead .............................................................. 8
Variable marketing expenses ..................................................................... 3
Fixed manufacturing overhead .............................................................. 25*
Total costs .............................................................................................. $88
*$2,100,000 total fixed manufacturing overhead/84,000 pairs of sunglasses

Jasper McKnight has enough idle capacity to accept a one-time-only special order from Arizona Glasses for 17,000 pairs of sunglasses at $63 per pair. Jasper McKnight will not incur any variable marketing expenses for the order.
Requirements
1. How would accepting the order affect Jasper McKnight's operating income? In addition to the special order's effect on profits, what other (longer-term qualitative) factors should Jasper McKnight's managers consider in deciding whether to accept the order?
2. Jasper McKnight's marketing manager, Nick Ferritto, argues against accepting the special order because the offer price of $63 is less than Jasper McKnight's $88 cost to make the sunglasses. Ferritto asks you, as one of Jasper McKnight's staff accountants, to explain whether his analysis is correct.

Answer 1

Solution

Jasper McKnight

1. Impact of accepting special order on the company’s operating income:

Analysis of profitability of special order:
Sales price per unit	$63
Varaible cost:
Direct material	$40
Direct labor	$12
Variable overhead	$8
Total variable cost	$60
Contribution margin per unit	$3

The acceptance of special order would increase the operating income by $51,000 ($3 x 17,000).

Other long-term qualitative factors to be considered include the impact on regular sales.

1. The analysis of company’s marketing manager is not correct.

Analysis of relevant costs –

All variable costs to make and market the product are relevant. However, since the company does not incur the variable marketing expenses of $3 per unit, on accepting the special order from Arizona Glasses, the total relevant cost adds up to $60, which is less than the offer price of $63, leaving a contribution margin per unit of $3.

Also, since the company has idle capacity the fixed cost is not relevant. Any contribution margin earned above the variable cost would further absorb the fixed cost burden. Hence, the fixed cost in total and per unit is not relevant and hence the marketing manager’s estimate of $88 cost per unit is incorrect. The fixed cost per unit of $25 is an irrelevant cost.

The relevant cost for the special order is $60 as shown in the above calculation.