Question

Problem 6-30B Comprehensive problem including special order, outsourcing, and segment elimination decisions

Rooney Company’s electronics division produces a DVD player. The vice president in charge of the division is evaluating the income statement showing annual revenues and expenses associated with the division’s operating activities. The relevant range for the production and sale of the DVD player is between 50,000 and 150,000 units per year.

Income Statement
Revenue (60,000 units × $70)	$4,200,000
Unit-level variable costs
Materials cost (60,000 × $40)	(2,400,000)
Labor cost (60,000 × $16)	(960,000)
Manufacturing overhead (60,000 × $3)	(180,000)
Shipping and handling (60,000 × $1)	(60,000)
Sales commissions (60,000 × $4)	(240,000)
Contribution margin	360,000
Fixed expenses
Advertising costs related to the division	(60,000)
Salary of production supervisor	(252,000)
Allocated companywide facility-level expenses	(240,000)
Net loss	$   (192,000)

Required (Consider each of the requirements independently.)

An international trading firm has approached top management about buying 30,000 DVD players for $63 each. It would sell the product in a foreign country, so that Rooney’s existing customers would not be affected. Because the offer was made directly to top management, no sales commissions on the transaction would be involved. Based on quantitative features alone, should Rooney accept the special order? Support your answer with appropriate computations. Specifically, by what amount would profitability increase or decrease if the special order is accepted?

Rooney has an opportunity to buy the 60,000 DVD players it currently makes from a foreign manufacturer for $62 each. The manufacturer has a good reputation for reliability and quality, and Rooney could continue to use its own logo, advertising program, and sales force to distribute the products. Should Rooney buy the DVD players or continue to make them? Support your answer with appropriate computations. Specifically, how much more or less would it cost to buy the DVD players than to make them? Would your answer change if the volume of sales were increased to 140,000 units?

Because the electronics division is currently operating at a loss, should it be eliminated from the company’s operations? Support your answer with appropriate computations. Specifically, by what amount would the segment’s elimination increase or decrease profitability?

Answer 1

1. Here, The company has idle capacity of production. Current sales are only 60,000 but it can manufacture upto 150,000 units.

The Variable cost on new order per unit =40+16+3+1= $ 60

Note: Because the offer was made directly to top management, no sales commissions on the transaction would be involved. Hence we won't consider sales commison for calculation variable cost.

Selling price per unit of new order = $ 63.

Contribution margin per unit = selling price - variable cost per unit = 63-60 = $ 3

Total contribution margin on new foreign order = number of unit x contribution per unit = 30,000 x 3 = $ 90,000.

As the contribution margin is positive and there is idle capacity to utilise the order is to be accepted.

Hence By accepting the new order loss can be reduced by $ 90,000.

2-a). Total cost if 60,000 units are manufactured inhouse = Sales + Net loss

= 4,200,000 + 192,000 = $ 4,392,000.

Total cost if purchased from foreign company.

purchase cost- Variable = 60,000 x 62 = 3,720,000

Shipping and handling = 60,000 x 1 = 60,000

Sales Commission = 60,000 x 4 = 240,000

Total Variable cost = 4,020,000

Fixed cost

Advertising costs related to the division = 60,000

Allocated companywide facility-level expenses = 240,000

Total fixed cost = 300,000

Total cost if purchased from foreign supplier = 4,020,000 + 300,000 = 4,320,000

Note : Salary of production supervisor is not considered as there is no production if purchased from foreign supplier

As the total cost is lower in purchase option than making inhouse it is advisable to purchase if the sales are @ 60,000 units.

2-b ) If sales are 140,000 units.

Variable cost if purchased from foreign supplier = 62+1+4= 67 per unit

Contribution per unit = 70-67 = $ 3

Total fixed cost = 300,000

Profit if purchased from foreign supplier = contribution -fixed expense= (140,000 x 3) - 300,000 = 120,000

Variable cost if manufacture = 40+16+3+1+4 = 64.

Contribution = 70-64 = 6 per unit

Total fixed cost = 300,000+252,000 = 552,000

Profit if manufactured inhouse = (140,000 x 6) - 552,000 = 288,000.

It is advisable to manufacture inhouse than to purchase if sales voluem is 140,000 units.

3. No, Though the electronics division is currently operating at a loss, the contribution is positive and the production capacity is also idle. So the company should try to increase the sales in this particular division to run in profits. At least the break even sales should be reached to avoid losses.

Break even sales = fixed cost / contribution per unit =552,000/6 = 92,000.

Hence if company could increase the sales upto 92,000 in the market no need to eleminate the divison from company operations.