Question

Sherene Nili manages a company that produces wedding gowns. She produces both a custom product that is made to order and a standard product that is sold in bridal salons. Her accountant prepared the following forecasted income statement for March, which is a busy month:

	Custom Dresses			Standard Dresses			Total
Number of dresses		10			20			30
Sales revenue	$	52,500		$	32,500		$	85,000
Materials	$	10,500		$	8,500		$	19,000
Labor		20,500			9,500			30,000
Machine depreciation		650			350			1,000
Rent		4,700			3,300			8,000
Heat and light		1,200			800			2,000
Other production costs								3,300
Marketing and administration								8,200
Total costs							$	71,500
Operating profit							$	13,500

Ms. Nili already has orders for the 10 custom dresses reflected in the March forecasted income statement. The depreciation charges are for machines used in the respective product lines. Machines depreciate at the rate of $1 per hour based on hours used, so these are variable costs. In March, cutting and sewing machines are expected to operate for 1,000 hours, of which 650 hours will be used to make custom dresses. The rent is for the building space, which has been leased for several years at $8,000 per month. The rent, heat, and light are allocated to the product lines based on the amount of floor space occupied.

A valued customer, who is a wedding consultant, has asked Ms. Nili for a special favor. This customer has a client who wants to get married in early April. Ms. Nili's company is working at capacity and would have to give up some other business to make this dress. She can't renege on custom orders already agreed to, but she can reduce the number of standard dresses produced in March to 10. Ms. Nili would lose permanently the opportunity to make up the lost production of standard dresses because she has no unused capacity for the foreseeable future. The customer is willing to pay $26,500 for the special order. Materials and labor for the order will cost $6,500 and $10,500, respectively. The special order would require 160 hours of machine time. Ms. Nili's company would save 175 hours of machine time from the standard dress business given up. Rent, heat and light, and other production costs would not be affected by the special order.

Required:

a-1. Calculate the differential operating profit (loss). (Select option "increase" or "decrease", keeping Without special order as the base. Select "none" if there is no effect.)

a-2. From an operating profit (loss) perspective for March, should Ms. Nili accept the order?

	Yes
	No

b. What is the minimum price Ms. Nili should accept to take the special order?

Answer 1

a-1 Differential operating profit will be as follows:

Operating Profit if special order is accepted (calculation shown below)	$         16,565
Less: Operating Profit with base forecast (no special order)	$       (13,500)
Differential Operating Profit	$           3,065

Forecast statement if special order is accepted	Amount/Qty	Total
For Custom Dresses
Number of dresses	11
Sales revenue (existing + 26,500)	$         79,000	$         79,000
Materials (existing + 6,500)	$         17,000
Labour (existing + 10,500)	$         31,000
Machine depreciation (exisitng + $1/hr*160 hrs)	$               810
Rent	$           4,700
Heat and Light	$           1,200
Total cost specific to custom dresses		$       (54,710)
For Standard Dresses
Number of dresses	10
Sales revenue (10 * (32,500/20))	$         16,250	$         16,250
Materials (10 * (8,500/20))	$           4,250
Labour (10 * (9,500/20))	$           4,750
Machine depreciation (exisitng - $1/hr * 175 hrs)	$               175
Rent	$           3,300
Heat and Light
Total cost specific to standard dresses		$       (12,475)
Common costs
Other Production Costs		$         (3,300)
Marketing and administration		$         (8,200)
Total Sales (Custom + Standard)		$         95,250
Total Costs (Custom + Standard + Common)		$       (78,685)
Operating profit (Total Sales - Total Costs)		$         16,565

a- 2 Yes, since Ms. Nili is making a higher profit with the special order, she should accept it.

b. The minimum price at which Ms Nili should charge the special order should be the price at which she would make the same margin had she not accepted the special order. the calculation are as follows:

Operating profit % at base forecast = 13,500 / 85,000 = 15.88%

So Ms Nili should be able to mae a 15.88% operating profit even with the special order. We can calculate the desired sales value then as follows:

Operating margin % of cost = 100 - 15.88 = 84.12%

Total costs forecast with special order = $ 78,685

Total sales revenue required to maintain same sales margin = $ 78,685 / 84.12% = $93,539

Sale price for special order = Total sales - Custom dress sales (without special order) - 10 standard dress sales

= $93,539 - $52,500 - $16,250

= $ 24,789

Therefore Ms Nili should charge a minimum of $ 24,789 so that she doesn't incur any loss on accepting the special order