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Integrative Exercise
Relevant Costing, Cost-Based Pricing, Cost Behavior, and Net Present Value Analysis for NoFat

Special Sales Offer Relevant Analysis

NoFat manufactures one product, olestra, and sells it to large potato chip manufacturers as the key ingredient in nonfat snack foods, including Ruffles, Lays, Doritos, and Tostitos brand products. For each of the past 3 years, sales of olestra have been far less than the expected annual volume of 125,000 pounds. Therefore, the company has ended each year with significant unused capacity. Due to a short shelf life, NoFat must sell every pound of olestra that it produces each year. As a result, NoFat's controller, Allyson Ashley, has decided to seek out potential special sales offers from other companies. One company, Patterson Union (PU)—a toxic waste cleanup company—offered to buy 10,000 pounds of olestra from NoFat during December for a price of $2.20 per pound. PU discovered through its research that olestra has proven to be very effective in cleaning up toxic waste locations designated as Superfund Sites by the U.S. Environmental Protection Agency. Allyson was excited, noting that "This is another way to use our expensive olestra plant!"

The annual costs incurred by NoFat to produce and sell 100,000 pounds of olestra are as follows:

Variable costs per pound:
Direct materials		$ 1.00
Variable manufacturing overhead		0.75
Sales commissions		0.50
Direct manufacturing labor		0.25
Total fixed costs:
Advertising		$ 3,000
Customer hotline service		4,000
Machine setups		40,000
Plant machinery lease		12,000

In addition, Allyson met with several of NoFat's key production managers and discovered the following information:

The special order could be produced without incurring any additional marketing or customer service costs.

NoFat owns the aging plant facility that it uses to manufacture olestra.

NoFat incurs costs to set up and clean its machines for each production run, or batch, of olestra that it produces. The total setup costs shown in the previous table represent the production of 20 batches during the year.

NoFat leases its plant machinery. The lease agreement is negotiated and signed on the first day of each year. NoFat currently leases enough machinery to produce 125,000 pounds of olestra.

PU requires that an independent quality team inspects any facility from which it makes purchases. The terms of the special sales offer would require NoFat to bear the $1,000 cost of the inspection team.

Required:

1. Conduct a relevant analysis of the special sales offer by calculating the following:

a. The relevant revenues associated with the special sales offer
$

b. The relevant costs associated with the special sales offer
$

c. The relevant profit associated with the special sales offer (Enter loss, if any, as negative amount.)
$

2. Based solely on financial factors, explain why NoFat should accept or reject PU's special sales offer.

The relevant cost is than the relevant revenue offered by PU, making the relevant (or incremental) profit —so,

3. Describe at least one qualitative factor that NoFat should consider, in addition to the financial factors, in making its final decision regarding the acceptance or rejection of the special sales offer.

A potentially important qualitative factor is , namely the public’s perception of olestra’s safety. In particular, some (possibly large) percentage of NoFat’s customers might be concerned that olestra is not a safe ingredient for human ingestion, given its apparent effectiveness in cleaning up toxic waste sites. As a result, the acceptance of PU’s special sales offer might significantly decrease NoFat’s regular sales of olestra.

Cost-Based Pricing

Assume for this question that NoFat rejected PU’s special sales offer because the $2.20 price suggested by PU was too low. In response to the rejection, PU asked NoFat to determine the price at which it would be willing to accept the special sales offer. For its regular sales, NoFat sets prices by marking up variable costs by 10%.

4. If Allyson decides to use NoFat’s 10% markup pricing method to set the price for PU’s special sales offer,

a. Calculate the price that NoFat would charge PU for each pound of olestra. Round your answer to the nearest cent.
$ per unit

b. Calculate the relevant profit that NoFat would earn if it set the special sales price by using its mark-up pricing method. Enter loss, if any, as negative amount. (Hint: Use the estimate of relevant costs that you calculated in response to Requirement 1b.)
$

c. Explain why NoFat should accept or reject the special sales offer if it uses its mark-up pricing method to set the special sales price.

NoFat should the special sales offer if PU will agree to pay the price of $ per unit that results from NoFat’s cost-plus pricing formula.

Incorporating a Long-Term Horizon into the Decision Analysis

Assume that Allyson's relevant analysis reveals that NoFat would earn a positive relevant profit of $10,000 from the special sale (i.e., the special sales alternative). However, after conducting this traditional, short-term relevant analysis, Allyson wonders whether it might be more profitable over the long-term to downsize the company by reducing its manufacturing capacity (i.e., its plant machinery and plant facility). She is aware that downsizing requires a multiyear time horizon because companies usually cannot increase or decrease fixed plant assets every year. Therefore, Allyson has decided to use a 5-year time horizon in her long-term decision analysis. She has identified the following information regarding capacity downsizing (i.e., the downsizing alternative):

The plant facility consists of several buildings. If it chooses to downsize its capacity, NoFat can immediately sell one of the buildings to an adjacent business for $30,000.

If it chooses to downsize its capacity, NoFat's annual lease cost for plant machinery will decrease to $9,000.

Therefore, Allyson must choose between these two alternatives: Accept the special sales offer each year and earn a $10,000 relevant profit for each of the next 5 years or reject the special sales offer and downsize as described above.

5. Assume that NoFat pays for all costs with cash. Also, assume a 10% discount rate, a 5-year time horizon, and all cash flows occur at the end of the year. Use an NPV approach to discount future cash flows to present value. To determine NPV, use the Exhibit to locate the present value of $1 to be multiplied by the cash inflow in Year 1.

a. Calculate the NPV of accepting the special sale with the assumed positive relevant profit of $10,000 per year (i.e., the special sales alternative). Round your answer to the nearest dollar.
$

b. Calculate the NPV of downsizing capacity as previously described (i.e., the downsizing alternative). Round your answer to the nearest dollar.
$

c. Based on the NPV of Calculations a and b, identify and explain which of these two alternatives is best for NoFat to pursue in the long term.

Based on the NPV of Requirements 5a and 5b, the alternative (i.e., Requirement 5b) appears to be the best long-term alternative for NoFat to pursue because it is estimated to provide a .

Answer 1

Ques 1:
a)The relevant revenues associated with the special sales offer
Price per pound number of pound= $2.20 x 10,000 = $22,000
of relevant (incremental) revenues from the special sale

b)
The relevant costs associated with the special sales offer
a)Relevant variable costs:
Direct materials................... $1.00
Variable manufacturing overhead........ $0.75
Direct manufacturing labor ...... $0.25
Total .............. $2.00/pound
So $2.00/pound x 10,000 special sales pound = $20,000 relevant variable costs

b)Relevant fixed costs:
Batch costs
= Cost per batch x number of batches required by special sales offer
= (Batch costs/number of batches) x (special sales units/number of units per batch)
= ($40,000/20) x [10,000/(100,000/20)]
= ($2,000 cost per batch) x (2 batches required by special sales offer)
= $4,000 batch cost for special sales offer
Plant inspection team cost if special sale is accepted = $1,000
Total relevant fixed cost = $4,000 + $1,000 = $5,000 relevant fixed cos
Total Relevant Costs from Special Sales Offer: $20,000 + $5,000 = $25,000

c)
The relevant profit associated with the special sales offer
Relevant Revenues............ $22,000
Relevant Cost............. (25,000)
Relevant profit ........... ($3,000)

Ques 2:

NoFat must reject PU's special sales offer because the relevant $ 25,000 fee is higher than the relevant income of $ 22,000 offered by PU, thus making a relevant (or additional) profit from ($ 3,000) negative.

Ques 3:

A potentially important qualitative factor is product reputation, namely Olestra's public perception of safety. In particular, some (perhaps large) percentages of NoFat customers may worry that Olestra is not a safe material for human consumption given the obvious effectiveness of cleaning toxic waste sites

Ques 4:
a.
Total revenue= (Number of units × Variable cost per unit) × 1.10
= [10,000 units × ($1.00 + $0.75 + $0.50 + $0.25)] × 1.10
= (10,000 units × $2.50) × 1.10
= $25,000 × 1.10
= $27,500

The selling price per unit = Total revenue from special sale/Number of units
= $27,500/10,000
= $2.75 selling price per unit

b.
Relevant revenue.....$27,500
Relevant costs......(25,000)
Relevant profit......$ 2,500

c.Yes, NoFat must accept a special offering if PU agrees to pay a price of $ 2.75 per unit, which is the result of NoFat's cost-plus pricing formula

Ques 5
a.
= Annual net cash inflow from special sales relevant profit* Discount factor at 10%
= $10,000*3.791
NPV= $37,910
of accepting special sales offer five-year time horizon

b.
a)Cash inflow from immediate sale of one building for $30,000 (no need to discount cash flow because it occurs at time 0)
b) Annual lease cost decreases from $12,000 to $9,000. This cost decrease of $3,000 represents an annual $3,000 increase inflow. The present value of this annuity equals:
= $3,000*3.791
= $11,371
Total NPV of downsizing = $30,000 + $11,373= $41,37

c.
Based on the NPV calculation in points a and b, alternative downsizing (point b) shows the alternative NoFat long term is better to be chosen because estimation shows that the positive NPV is greater ($ 41,313) than the calculation of alternative specific sales at point a ($ 37,910)