Question

As you know, we have been renting Building X for several years to the Smith Company for $30,000 per year. Their lease expires at the end of the year. Instead of renewing the lease, I have been thinking that we should use that part of our plant to manufacture a new product. The direct materials cost for the new product will total $80 per unit. To have a place to store finished units of the product, we will rent a small warehouse nearby. The rental cost will be $500 per month. In addition, we must rent equipment for use in producing the new product; the rental cost will be $4,000 per month. We will hire workers to manufacture the new product, with the direct labor cost amounting to $60 per unit. The space in Building X will continue to be depreciated on a straight-line basis, as in prior years. This depreciation is $8,000 per year. Advertising costs for the new product will total $50,000 per year. I am going to hire a supervisor to oversee production; her salary will be $3,500 per month. Electricity for operating the machines will be $1 per unit. The cost of shipping the new product to customers will be $9 per unit. To provide funds to purchase materials, meet payroll, and so forth, we will have to liquidate some temporary investments. These investments are presently yielding a return of about $3,000 per year. I would like to sell the new product for $200 per unit. The marketing department thinks that at that price we should be able to sell 4,000 units every year. Please review the costs below and let me know if you think the costs should be classified as a product cost, a period cost, or an opportunity cost (pick one). I also would like to know if the behavior of the product cost or period cost is fixed or variable. Opportunity costs should not be classified as fixed or variable. (Hint: There are two opportunity costs in this problem. They are the two items that are ‘revenue’ in the list of costs.) Name of Cost Variable or Fixed Cost Product Cost Period Cost Opportunity Cost Rental revenue (from Smith Co.) forgone, $30,000 per year Direct materials cost, $80 per unit Rental cost of warehouse, $500 per month Rental cost of equipment, $4,000 per month Direct labor cost, $60 per unit Depreciation of Building X, $8,000 per year Advertising cost, $50,000 per year Supervisor’s salary, $3,500 per month Electricity for machines, $1 per unit Shipping cost, $9 per unit Revenue earned on investments, $3,000 per year Based on the information above, do you think we should manufacture the new product or should we continue to rent to Smith Company? In the space below and on the next pages, please provide me with numbers to support your answer. Are there any costs that are not relevant in this decision? How many units do we need to sell in order to ‘break even?’ Option 1: Continue to rent to Smith Company Rental revenue from Smith _______________ Investment revenue _______________ Total revenue _______________ Expenses: ________________________ _______________ Net operating income _______________ Option 2: Manufacture the new product Henry Hawkins Industries Contribution Format Income Statement: New Product For the Year Total Per Unit Sales (4,000 units) $800,000 $200 Variable expenses: _____________________ _______________ ______ _____________________ _______________ ______ _____________________ _______________ ______ _____________________ _______________ ______ Total variable expenses _______________ ______ Contribution margin _______________ ______ Fixed expenses: _____________________ _______________ _____________________ _______________ _____________________ _______________ _____________________ _______________ _____________________ _______________ Total fixed expenses _______________ Net operating income _______________ Questions: 1. Do you recommend Option 1 or Option 2? 2. Which cost is not relevant to the decision? (Hint: which cost shows up in both options.) 3. How many units of the new product do we need to sell in order to ‘break-even?’ (Break-even is where the net operating income is zero.)

Answer 1

Product Cost refers to the costs that are incurred to produce or acquire a product. It includes direct material, direct labour, production supplies and factory overhead. Factory overhead includes Supervisor's salary, factory rent, factory insurance etc.

Period Cost is associated with the passage of time than with a particular transactional event.

In the given question Warehouse rent, Equipment rent, Advertising Cost and shipping charges are period costs. However, they are relevant in the decision making and so they shall be considered while evaluating the two options.

Opportunity Cost refers to the benefit forgone due to a decision by ignoring the next best alternative course of action.

Depreciation is a fixed period cost and it shall not be considered in the decision making process as it shall continue to occur in the same amount in either of the options.

The Classification of the expenses is as shown below:

Name of Cost	Amount	Nature of Cost	Remark
Rental Revenue foregone	$30000	Opportunity Cost	Neither Variable nor Fixed
Direct Material	$80 p.u.	Product Cost	Variable Cost
Direct Labour	$60 p.u.	Product Cost	Variable Cost
Warehouse Rent	$500 per month	Period Cost	Fixed Cost
Equipment rent	$4000 per month	Period Cost	Fixed Cost
Depreciation	$8000 p.a.	Period Cost	Fixed Cost
Advertising cost	$50000 p.a.	Period Cost	Fixed Cost
Supervisor Salary	$3500 per month	Product Cost	Fixed Cost
Electricity charges	$1 p.u.	Product Cost	Variable Cost
Shipping Charges	$9 p.u	Period Cost	Variable cost
Investment yield foregone	$3000 p.a	Opportunity Cost	Neither Fixed nor Variable cost

Option 1: Continue to rent to Smith Company:

a) Rental revenue from Smith= $30,000

b) Investment Revenue = $3000

c) Total Revenue = a+b = $33,000

d) Expenses = NIL

e) Net Operating Income = c-d = $33,000

Option 2: Manufacture the Product Henry Hawkins Industries :

The Contribution margin and Net Operating Income is computed as below:

(a) Revenue from Product (4000 unit @ $200 p.u)	800000
Less: Variable Costs:
Direct Materials (4000* $80 p.u)	320000
Direct Labour (4000*$60 p.u)	240000
Electricity Charges (4000*$1 p.u)	4000
Shipping Charges (4000*$ 9 p.u)	36000
(b)Total Variable Cost	600000
(c) Contribution Margin (a-b)	200000
Less: Fixed Costs:
Warehouse Rental Charges (500*12)	6000
Equipment rental charges (4000*12)	48000
Advertising	50000
Supervisor's Salary (3500*12)	42000
(d)Total Fixed Costs	146000
Net Operating Income (c-d)	54000

Answer to Q 1:

As we can see the net operating income increases by $(54000-33000)= $21,000 if we choose option 2 i.e. if we manufacture the Product Henry Hawkins Industries instead of continuing to rent to Smith company, we choose Option 2.

Answer to Q 2:

Depreciation is a fixed period cost and is not relevant to the decision as it shall continue to occur in the same amount in both the options.

Answer to Q 3:

Break even point is the point where the decision maker is indifferent as to the choice of option i.e. both the options will provide the same amount of profit.

Let the number of units at which we shall break even be x.

So According to the problem,

(200-80-60-1-9)x-146000 = 33000

or, 50x = 33000+146000

or, x =179000/50 =3580

So, the number of units of the new product that we need to sell in order to break even = 3580 units.