Question

7. Old Vine Vineyard produces premium wine. Its success in the industry is due to its quality, although all of its customers, wine shops and specialty grocery stores, are very cost conscious and negotiate for price cuts on all large orders. Noting that the wine industry is becoming increasingly competitive, Old Vine is looking for a way to meet the challenge. It is negotiating with Eastern Seasons, a regional specialty grocery store, to purchase a large order of wine. Old Vine is currently producing at under-capacity and would like to keep its production facilities, gaining better economies of scale by increasing production. Eastern Seasons has agreed to a large order but only at a price of $31 per bottle. The special order can be purchased in one batch with available capacity. Old Vine prepared these data:

Next month's operating information (per unit, for 10,000 bottles, made in 10 batches of 1,000 each):

Sales Price                                                       $46

Per Unit costs:

Variable manufacturing costs                          16

Batch level costs                       4

Variable marketing costs                    9

Fixed manufacturing costs                   6

Fixed marketing costs                       1

Special order information – order is produced in one batch

Sales units                                  2,000

Sales price per bottle                       $31

No variable marketing costs are associated with this order, but Old Vine has spent $2,500 during the past two months trying to get Eastern Seasons to purchase the special order.

Required:

A. How much will the special order change Old Vine's total operating income?

B. How much would the special order change Old Vine's total operating income if Old Vine is operating at full capacity and would lose the sale of the 2,000 bottles to regular customers?

C. How might the special order fit into Old Vine's competitive strategy?

Answer 1

Old Vine Vineyard, the 'company' is operating at under-capacity. So there is sufficient capacity to produce 2000 more bottles.

Some basics;- Variable cost is incurred only for the actual 'number of units' produced. Batch level cost (assumed it is per unit) is incurred per batch and allocated to all the units in a batch. Fixed costs are incurred based on normal operating capacity, irrespective of the actual number of units produced. (Hint: these are the costs which help to achieve economies of scale as they remain fixed even with increased output)

Operating income or operating profit, or net operating profit is EBIT (Earnings Before Interest and Taxes). We calculate it using the following equation: revenues minus cost of goods sold (COGS) and other operating expenses.

Now, as per the question, the company normally produces 10,000 bottles in a batch of 1000 each, ie 10 batches. If the company takes the new order, 2000 more bottles will be produced in 1 batch.

A. First we will calculate Operating Income if only 10,000 bottles are produced. (All amounts in $)

Per Unit Sale Price= 46

Sale Price for 10,000 bottles= 46x10000 = 460,000

Variable Manufacturing cost (16 per unit)= 16x10000 = 160,000

Batch cost for 10 batches (4 per unit for batch of 1000 units, that is 4000 per batch)= 4000x10 = 40,000

Variable Manufacturing cost (9 per unit)= 9x10000= 90,000

Fixed Manufacturing Cost(6 per unit for 10000 units)= 60,000 (it will remain fixed even if output increases)

Fixed marketing cost( 1 per unit for 10000 units)= 10,000 (also will remain fixed even with increased output)

Operating Profit= Sale Price Less Variable manufacturing cost Less batch cost Less variable marketing cost Less fixed manufacturing cost Less fixed marketing cost

= 460,000-160,000-40,000-90,000-60,000-10,000 = 100,000

Now, if new order of 2000 bottles is also produced. Total bottles produced is 12,000.

Sale Price= 46x10000 + 31x2000 = 522,000

Variable manufacturing cost= 16x12000 = 192,000

Batch level cost (as explained earlier it is 4000 per batch, and for batch of 2000 units also it will not change as per unit cost is given to allocate the overheads) = (10+1) x4000= 44,000

Variable marketing cost= 9x 12000= 108,000

Fixed Manufacturing cost (it will remain same)= 60,000

Fixed marketing cost (it will remain same)= 10,000

Cost of $2500 already incurred is sunk cost and hence it will not be taken into consideration.

New Operating income= 522,000-192,000-44,000-108,000-60,000-10,000

= 108,000

Special order will increase the Operating income of the company from 100,000 to 108,000, i.e. increase of $8000

B. If the company is operating at full capacity, then the operating income for 10,000 bottles will remain same, which is 100,000 as calculated above.

But the operating income along with special order will change as now the company will only be able to produce 10,000 bottles, which includes 8000 bottles for original sale and 2000 bottles for special order.

Operating income when producing special order-

Sale Price= 46x8000 + 31x2000= 430,000

Variable manufacturing cost= 16x10000= 160,000

Batch level cost (now 8 batches of normal cycle of 1000 units each and 1 batch of special order of 2000 units)= 9x4000= 36,000

Variable marketing cost= 9x10000= 90,000

Fixed Manufacturing cost(will not change)= 60,000

Fixed marketing cost (will not change)= 10,000

Cost of 2500 is sunk cost hence not considered.

Operating Income= 430,000- 160,000-36,000-90,000-60,000-10,000= 74,000

Hence the special order will decrease the operating income from 100,000 to 74,000 which is decrease of $26,000

C. As can be seen from part A and B, if the company has idle capacity, it will be beneficial to take the special order as the company is recovering the variable cost and getting positive contribution even with sale price of 31. But if the company is not having any idle capacity, then it will not be advisable to take the special order as it will decrease its operating profit.