Question

Cost Formulas, Single and Multiple Activity Drivers, Coefficient of Correlation

Kimball Company has developed the following cost formulas:

Material usage: Y_m = $85X; r = 0.97

Labor usage (direct): Y_l = $17X; r = 0.96

Overhead activity: Y_o = $349,000 + $100X; r = 0.73

Selling activity: Y_s = $52,000 + $12X; r = 0.92

where

X = Direct labor hours

The company has a policy of producing on demand and keeps very little, if any, finished goods inventory (thus, units produced equals units sold). Each unit uses one direct labor hour for production.

The president of Kimball Company has recently implemented a policy that any special orders will be accepted if they cover the costs that the orders cause. This policy was implemented because Kimball's industry is in a recession and the company is producing well below capacity (and expects to continue doing so for the coming year). The president is willing to accept orders that minimally cover their variable costs so that the company can keep its employees and avoid layoffs. Also, any orders above variable costs will increase overall profitability of the company.

Required:

1. Compute the total unit variable cost. Suppose that Kimball has an opportunity to accept an order for 20,000 units at $224 per unit.
$

Should Kimball accept the order? (The order would not displace any of Kimball’s regular orders.)

2. Suppose that a multiple regression equation is developed for overhead costs: Y = $102,000 + $100X₁ + $5,000X₂ + $300X₃, where X₁ = direct labor hours, X₂ = number of setups, and X₃ = engineering hours. The coefficient of determination for the equation is 0.92. Assume that the order of 20,000 units requires 12 setups and 600 engineering hours. Given this new information, should the company accept the special order referred to in Requirement 1?

Answer 1

1.

Cost Sheet for 20,000 units
Particulars	Working	Amount
Material	($85x20000)X0.97	1649000
Labour	($17x20,000)X0.96	326400
Variable Overhead	($100x20,000)X0.73	1460000
Variable Selling Expense	($12x20,000)X0.92	220800
Total Relevant Expenditure		$3656200
No. of Units		20,000
Per Unit Cost		$ 182.81

Conclusion: As the new proposal for the product is $224 which is much higher than the cost, hence Kimball should accept the order.

Note: Fixed Overheads and Fixed selling expense are not part of relevant cost as they continue to occur even if the order is not accepted otherwise hence irrelevant for decision making.

2.

New Overhead Cost,Y =[{ $100 X 20,000 + $5,000 X 12 + $300 X 600} x 0.92]= $ 2060800

Incremental Overhead from Case 1 Above = $ 2060800- 1460000= $ 600800

Incremental Overhead Cost per Unit = $ 600800 / 20,000 = $30.04

Total New Cost= $ 182.1 + 30.04 = 212.14

Conclusion: As long as the revenue which is $ 224 in the case exists, and it covers the relevant cost as per the company's policy, it should accept the decision.

Fixed Cost/Overhead is still irrelevant for the decision making.