Question

Required information [The following information applies to the questions displayed below.] Green Grow Inc. (GGI) manufactures lawn fertilizer. Because of the product's very high quality, GGI often receives special orders from agricultural research groups. For each type of fertilizer sold, each bag is carefully filled to have the precise mix of components advertised for that type of fertilizer. GGI's operating capacity is 37,000 one-hundred-pound bags per month, and it currently is selling 35,000 bags manufactured in 35 batches of 1,000 bags each. The firm just received a request for a special order of 8,000 one-hundred-pound bags of fertilizer for $220,000 from APAC, a research organization. The production costs would be the same, but there would be no variable selling costs. Delivery and other packaging and distribution services would cause a one-time $6,000 cost for GGI. The special order would be processed in two batches of 4,000 bags each. (No incremental batch-level costs are anticipated. Most of the batch-level costs in this case are short-term fixed costs, such as salaries and depreciation.) The following information is provided about GGI's current operations: $ 50 Sales and production cost data for 35,000 bags, per bag: Sales price Variable manufacturing costs Variable selling costs Fixed manufacturing costs Fixed marketing costs No marketing costs would be associated with the special order. Because the order would be used in research and consistency is critical, APAC requires that GGI fill the entire order of 8,000 bags. Required: 1. What is the total relevant cost of filling this special sales order? 2. What would be the change in operating income if the special order is accepted? 3. What is the break-even selling price per unit for the special sales order (i.e., what is the selling price that would result in a zero effect on operating income)? 4. Prepare comparative income statements, using the contribution format, for both the current situation and assuming the special order is accepted at the break-even price determined in requirement 3.

Answer 1

1) The relevant cost of filling this special order will include all the cost incurred for fulfilling the special order and any loss of the contribution margin from sale of bags in current situation.

Under the current situation the excess capacity is 2,000 bags (37,000 - 35,000), whereas the special order is for 8,000 bags. Hence there will be a loss of contribution margin on 6,000 bags (8,000-2,000) which will be charged as relevant cost to special order.

Contribution margin per bag for current situation = Sales - Total Variable cost

= $50 - ($27+$4) = $19 per bag

Calculation of Relevant Cost of filling Special Sales Order (Amounts in $)

Variable Manufacturing Costs (8,000 bags*$27 per bags)	216,000
Delivery and Other Packaging cost	6,000
Loss of contribution (6,000 bags*$19)	114,000
Total Relevant Cost of filling special sales order	336,000

2) Calculation of Operating Income in Both Situations (Amounts in $)

	Current Situation	If Special Order Accepted
Revenue (A)	1,750,000 (35,000*$50)	1,670,000 [(29,000*$50)+220,000]
Variable costs:
Variable manufacturing costs	945,000 (35,000*$27)	999,000 (37,000*$27)
Variable selling costs	140,000 (35,000*$4)	116,000 (29,000*$4)
Total variable costs (B)	1,085,000	1,115,000
Contribution Margin (C = A-B)	665,000	555,000
Special order delivery cost (D)	0	6,000
Fixed Manufacturing cost (E)	,420,000 (35,000*$12)	420,000 (35,000*$12)
Fixed marketing costs (F)	175,000 (35,000*$5)	175,000 (35,000*$5)
Net Operating Income (C-D-E-F)	70,000	(46,000)

There is a decrease in net income by $116,000 (46,000 loss+70,000).

Alternatively:

Decrease in operating income = Revenue from special order - relevant cost of special order

= $220,000 - $336,000 = $116,000

3) The break even sale price is the price at which net operating income will remain same as operating income under current situation (i.e. $70,000). For this we need to formulate an equation assuming selling price per unit be equal to X.

Total Revenue = Variable Cost+Fixed Cost+Special Order cost+required Operating Income

[(29,000*$50)+(8,000 X)] = 1,115,000+(420,000+175,000)+6,000+70,000

1,450,0000+8,000 X = 1,786,000

8,000 X = 1,786,000 - 1,450,000 = $336,000

X = $336,000/8,000 = $42 per bag

Therefore selling price of $42 per bag would result in zero effect on operating income.

4) Calculation of Operating Income in Both Situations   (Amounts in $)

	Current Situation	If Special Order Accepted
Revenue (A)	1,750,000 (35,000*$50)	1,786,000 [(29,000*$50)+(8,000*$42)]
Variable costs:
Variable manufacturing costs	945,000 (35,000*$27)	999,000 (37,000*$27)
Variable selling costs	140,000 (35,000*$4)	116,000 (29,000*$4)
Total variable costs (B)	1,085,000	1,115,000
Contribution Margin (C = A-B)	665,000	671,000
Special order delivery cost (D)	0	6,000
Fixed Manufacturing cost (E)	,420,000 (35,000*$12)	420,000 (35,000*$12)
Fixed marketing costs (F)	175,000 (35,000*$5)	175,000 (35,000*$5)
Net Operating Income (C-D-E-F)	70,000	70,000