Question

Emerald City Wear, Inc. (ECW, Inc.)^¨

Two alums of the UW Foster School of Business founded Emerald City Wear (ECW), a clothing manufacturer located in Seattle. Their strategy is to produce lightweight, warm, water-resistant garments suited to the Pacific Northwest’s mild and damp climate.

One of their garments is a reversible zip-front vest. While ECW can make up to 10,000 of these in a month with its current facilities, its normal production and sales activity level has regularly been 8,000 vests a month. Last November, the alums received an inquiry from the UW Bothell for 1,000 vests of various sizes with the UW Bothell School logo (shown above) embroidered on the front, to be distributed to faculty and donors. This was expected to be a one-time order and ECW would need to manufacture the vests in December to be ready by December 18 for distribution at the School’s holiday event.

According to ECW’s accounting system, the cost of producing and selling a single regular vest (without the special logo) at current activity level was as follows:

Direct materials (e.g., fabric and zippers)	$6.50
Direct labor (e.g., cutters and stitchers)	5.00
Variable overhead	2.50
Fixed overhead*(e.g., depreciation of building and equipment, property taxes, insurance, managers’ salaries, utilities)	4.00
Variable selling expenses (e.g., sales commissions and freight costs)	1.50
Fixed selling and administrative expenses (e.g., showroom and office costs)**	2.00
Total cost per vest	$21.50

* determined at normal capacity and allocated according to direct labor hours

** allocated based on ‘ability to bear’.

The normal selling price for a regular vest is $30.

ECW does not have the necessary equipment to do the embroidering of the UW Bothell School logo, so that would need to be outsourced to another company for a flat fee of $1,000.

The owners of ECW are conscious of the fact that the UW Bothell has had other bids, and because they are loyal alums, they would like to keep their bid to $18 per vest. This order is not expected to affect ECW’s regular sales.

Questions: (treat each question below independently)

1.   If the order is accepted at a bid price of $18 per vest, by how much will ECW’s December profits change? That is, will profits go up or down as a result of the order, and by how much?

2. Now assume that ECW already has orders from regular customers for 10,000 vests for December. If it supplies the vests to UW Bothell at $18 per vest, what will be the effect on its December profits?

3. All the data for regular vests remains unchanged. Assume that the company now has 500 of them left over from last year. However, they are chartreuse (a bright yellow-green) and have not sold at regular prices. If these vests must be sold through regular channels but at reduced prices, what cost is relevant for establishing the minimum selling price for these vests? Why?

Answer 1

1.

Calculation of Contribution margin

Sales Price	30.00
Variable Costs:
- Direct Material	(6.50)
- Direct Labour	(5.00)
- Variable Overhead	(2.50)
- Variable Selling Expenses	(1.50)
Contribution margin per unit	14.50
Contribution margin for 8,000 units	1,16,000
Fixed Costs:
- Fixed Overhead [4*10000]	(40,000)
- Fixed Selling & Admin Expense [2*8000]	(16,000)
Regular Net Income	60,000

If the order is accepted at a bid price of $18 per vest, contribution margin of $ 3.50 per unit will be earned and a flat fee of $ 1,000 is to be paid to for embroidering of logo.

Net increase / (decrease) in profit  = (3.50 * 1000) - 1000 = 2,500

Total Profit = 60,000 + 2,500 = 62,500

2.Assuming that ECW already has orders from regular customers for 10,000 vests, its regular profit would have been as follows:

Contribution margin per unit	14.50
Contribution margin for 10,000 units	1,45,000
Fixed Costs:
- Fixed Overhead [4*10000]	(40,000)
- Fixed Selling & Admin Expense [2*8000]	(16,000)
Regular Net Income	89,000

If it supplies the 1,000 vests to UW Bothell at $18 per vest, its total profit will be as follows:

Contribution margin per unit on vests sold @ 30	14.50
Contribution margin for 9,000 units (A)	1,30,500
Contribution margin per unit on vests sold @ 18	3.50
Contribution margin for 1,000 units (B)	3,500
Total Contribution margin (A)+(B)	1,34,000
Fixed Costs:
- Fixed Overhead [4*10000]	(40,000)
- Fixed Selling & Admin Expense [2*8000]	(16,000)
- Flat fee for embroidering logo	(1,000)
Regular Net Income	77,000

Net reduction in profit = 89,000 - 78,000 = 12,000

3.

500 vests left over from last year.

Variable selling cost is relevant for establishing the minimum selling price for these vests. All other costs are irrelevant/sunk cost.

Thus minimum price per vest will be $ 1.50