Question

You have been approached by a potential client who could bring you considerable business. She says, "I'd like to find an alternative vendor for my future orders of 5,000/yr., but their pricing must be competitive."

Your CFO has supplied you with the following information. Current product standard costs are as follows:

• Selling price per unit: $5,000
• $1,400/unit direct material
• $400/unit direct labor
• $200/unit variable overhead
• $200/unit fixed overhead (this figure is the result of the budgeted fixed overhead of $2,000,000 and budgeted sales volume of 10,000 units)
• Income Tax rate = 40%

1. What is the lowest possible price you could offer to this potential customer (you know that you have sufficient capacity without working overtime and without adding any new equipment to make this order)? Please show your calculations.
2. In terms of capacity, under what conditions would offering this lowest possible price be a bad decision? Why?
3. Create a pro-forma income statement to show a net income/net loss for the year.
4. You have been considering investing in automation to eliminate some factory labor if you get this large order. This technology advancement will cost an added $100,000/yr. to lease (net of taxes), but it will reduce labor cost/unit on the customer's units by 50%. How would this change the lowest possible price you could offer to this potential customer and at least still break even? Please show your calculations

Answer 1

Cost calculation of the product:                 Existing                                                             New price

Sales volume      (units)                                  10000                                                                5000

a)Sales price 10000@5000                           50,000000           5000@5000                       25000000

                                                                           =========                                                       =======

b)Variable Overhead

Direct Material 10000@1400                      14,000000           5000@1400                       7000000

Direct Labor        10000@400                       4000000              5000@1400                       2000000

Variable Overhead 10000@200                  2000000              5000@200                         1000000

                                                                           ======                                                              ======

Total                                                                  20000000                                                         10000000

                                                                           =======                                                           ========

Contribution (Sales-Variable cost)              30000000                                                         15000000

Fixed overhead                                               2000000                                                           1000000

                                                                           -=====                                                              =======

Net Profit (Contr.- FO)                                   28000000                                                         14000000

                                                                           ========                                                         =======

The lowest possible price we can offer ( Contribution/sales)=15000000/5000= 3000 per unit.

It will be very good decision because it will not impact on Fixed overhead.

If we will consider the new technology then labor cost will decrease by 50%

DM 14000000+DL2000000+2000000=18000000

Sales-Overhead=50000000-18000000=32000000-2000000=1200000

Less: New technology                                                                      100000

                                                                                                         ========

Net profit                                                                                       1100000