Question

“We’ve got a special order for 10,000 units from XYZ Inc.” said Harry Hope, CEO of Widgets R Us (WRU). If we get this order, this can mean a lot of future business from this customer in the future. WRU has extra capacity and accepting this deal will not impact sales from their current customer base.

XYZ is only willing to pay $10 per unit.

If overhead costs are overapplied, WRU may lose out on a profitable deal.

At the start of the year, XYZ’s Fixed Manufacturing Overhead was estimated at $100,000 for the year, based on capacities of 40,000 machine hours and 50,000 direct labour hours.

The variable costs for this order – including variable overhead, amount to $6 per unit.

Each unit requires 2 machine hours and 1 labour hour to produce.

Required:

Determine what the manufacturing costs would be if machine hours are used as the allocation base.

Determine what the manufacturing costs would be if direct labor hours are used as the allocation base.

Determine which overhead allocation basis would result in the best decision for WRU. Support your decision.

Should WRU accept this special order from XYZ? Make sure you state why or why not.

Answer 1

a) If machine hours are used as an allocation base, then predetermined overhead rate per machine hour will be:-

Overhead rate per machine hour = Total Fixed Manufacturing Overhead/Machine hours

= $100,000/40,000 = $2.50 per machine hour

Total units in the special order = 10,000 units

Machine hours required per unit = 2 machine hours

Total machine hours required for special order = 10,000 units*2 machine hour = 20,000 machine hours

Fixed manufacturing overhead = 20,000 machine hours*$2.50 per machine hour

= $50,000

Total manufacturing cost for the order = Variable costs + Fixed manufacturing overhead

= (10,000 units*$6 per unit) + $50,000

= $60,000+$50,000 = $110,000

b) If direct labor hours are used as an allocation base, then predetermined overhead rate per direct labor hour will be:-

Overhead rate per machine hour = Total Fixed Manufacturing Overhead/Direct Labor hours

= $100,000/50,000 = $2 per direct labor hour

Total units in the special order = 10,000 units

Labor hours required per unit = 1 machine hours

Total labor hours required for special order = 10,000 units*1 labor hour = 10,000 labor hours

Fixed manufacturing overhead = 10,000 labor hours*$2 per labor hour

= $20,000

Total manufacturing cost for the order = Variable costs + Fixed manufacturing overhead

= (10,000 units*$6 per unit) + $20,000

= $60,000+$20,000 = $80,000

c) As XYZ is only willing to pay $10 per unit, the use of direct labor hours as cost allocation base would result in the best decision for WRU. The total manufacturing cost per unit by using allocation base of direct labor hours is $8 per unit which is less than $10 (i.e. the maximum price payable by XYZ). Hence, the company should use direct labor hours as the overhead allocation base for WRU.

d) WRU has extra capacity and accepting this deal will not impact sales from their current customer base. Hence in this case, the relevant cost for deciding whether to accept the order or not is the variable cost for the product which is $6 per unit. Therefore, the company should accept this special order from XYZ because it results in contribution of $4 per unit ($10 - $6).