Question

Huang Automotive is presently operating at 75% of capacity. The company recently received an offer from a Korean truck manufacturer to purchase 22,500 units of a power steering system component for $196 per unit. Peter Wu, vice-president of sales, notes that although there will be an additional $3.00 shipping cost for each component, he thinks that accepting the order will get the company's "foot in the door" of an expanding international market. To determine variable and fixed costs, Huang's accountant used the high-low method with the following production and cost information for the last two years: 201,000 units $16,984,500 4,623,000 Direct material costs Direct labor costs Overhead costs Selling and administrative costs Total costs Total costs per unit 20,653,000 12,012,000 $54,272,500 $270.01 222,000 units $18,759,000 5,106,000 21,766,000 12,264,000 $57,895,000 $260.79 T.J. Chan, vice-president of engineering, feels that any new market should first show its profitability and that the $196 per unit offer is not only below the regular $250 selling price, but it's below the unit cost of the component. She also points out that there will be additional setup costs of $290,000 and that Huang will have to lease some special equipment for $210,000. REQUIRED [6 tries] 1. Using the high-low method to determine cost behavior, what would the expected profit be on the special order (use a negative sign for a loss)?

Answer 1

The expected profit on the special order = -38750

Working:

First determine which cost is variable and which is fixed
Direct Material Cost
At 201,000 Units, Per unit Material Cost	$                84.50	=16984500/201000
At 222,000 Units, Per unit Material Cost	$                84.50	=18759000/222000
So Material Cost is same per year that means Material Cost is Variable Cost
Direct Labor Cost
At 201,000 Units, Per unit Labor Cost	23	=4623000/201000
At 222,000 Units, Per unit Labor Cost	23	=5106000/222000
So Labor Cost is same per year that means Labor Cost is also Variable Cost
Direct Overhead Cost
At 201,000 Units, Per unit Overhead Cost	102.75	=20653000/201000
At 222,000 Units, Per unit Overhead Cost	98.05	=21766000/222000
So Overhead Cost is not same per year that means Overhead Cost is Mixed Cost.
Variable Overhead Cost = Change in Cost / Change in Units
= ($21766000 - 20653000) / (222,000 – 201,000 Units)
Variable Overhead Cost = $53 Per Unit
Fixed Overhead Cost = Total Cost – Variable Cost
At 201,000 Units
= $20653000 – (201,000 Units * $53 per unit)
Fixed Overhead Cost = $10,000,000
Direct Selling and Adm. Cost
At 201,000 Units, Per unit Selling and Adm. Cost	59.76	=12012000/201000
At 222,000 Units, Per unit Selling and Adm. Cost	55.24	=12264000/222000
So Selling and Adm. Cost is not same per year that means Selling and Adm. Cost Cost is Mixed Cost.
Variable Selling and Adm. Cost = Change in Cost / Change in Units
= ($12264000 - 12012000) / (222,000 – 201,000 Units)
Variable Selling and Adm. Cost = $12.0 Per Unit
Fixed Selling and Adm. Cost = Total Cost – Variable Cost
At 202,000 Units
= $12012000– (201,000 Units * $12.0 per unit)
Fixed Selling and Adm. Cost = $9,600,000
Now we know the Variable and Fixed Cost, which will help us determine whether we should accept this order or not.
If we will accept this order then we will only incur variable Cost, as Fixed Cost doesn’t change with change in Production or Sales.
	Cost
Sales (22,500 Units * 196)	4410000
Less: Cost
Existing Cost
Material (22,500 Units * 84.50)	1901250
Labor (22,500 Units * 23.0)	517500
Variable Overhead (22,500 Units * 573	1192500
Variable Selling and Adm. (22,500 Units * 12.0)	270000
New Cost
Shipping Cost (22,500 Units * 3.0)	67500
Setup Cost	290000
Lease Cost	210000
Total Cost	4448750
Net Income	-38750
The expected profit on the special order = -38750
Note:
There are some new cost which we will consider in Decision Making
Conclusion
We should not accept this order as it will decrease our Net Income by $38750