Question

The Phone Company has the following costs of producing and selling a cell phone assuming it produces and sells the normal volume of 100,000 of these cell phones per month:

Per unit manufacturing cost

            Direct materials                                              $50.00

            Direct labor                                                     10.00

            Variable manufacturing overhead cost             40.00

            Fixed manufacturing overhead cost                 30.00

Per unit selling cost

            Variable                                                          15.00

            Fixed                                                               10.00

Note that 100,000 (normal volume of production and sales) is the denominator used to calculate and allocate fixed costs per unit (regardless of the number of units actually produced). Any under- or over-allocated overhead will be adjusted at the end of the year to COGS. The selling price of a cell phone is $250, unless otherwise stated in the questions below. Variable selling costs are incurred only if (and when) the phones are sold.

Each situation below is independent of the other situations. That is, when you answer one question, assume that the situations described in other questions have not occurred. When you are considering opportunities for increased sales, assume that Phone Company has enough manufacturing and sales capacity to make these sales without incurring additional fixed costs. Ignore tax issues: just think in terms of operating income.

1. What is the unit cost (inventory value) of a cell phone on the Phone Company’s balance sheet for external reporting?

2. The Phone Company currently produces and sells 100,000 cell phones each month. The company’s marketing research department estimates that the sales volume of cell phones would increase by 20% if the price per phone is reduced to $200. If the price is reduced to $200, then will this increase or decrease the company’s operating income, and by how much?

3. The Phone Company is considering entering into a contract to provide Service Provider Company with 10,000 cell phones per month, in addition to its existing business. The contract would require Service Provider to reimburse Phone Company for its full manufacturing costs per unit plus an additional fee of $100 per phone. Assume that the above-mentioned allocation rates for overhead costs will not change during the year as a result of taking this contract. That is, the allocation rates will remain the same regardless of any under- or over-allocated overhead caused by accepting the order. The customer will not be charged or credited with any under- or over-allocation that happened during the year. Any over- or underallocated overhead will be charged or credited to Phone Company’s COGS at the end of the year. The Phone Company would incur no variable selling costs related to this contract. How much would Phone Company’s monthly operating income increase or decrease as a result of taking this contract?

Answer 1

Solution

Phone Company

1. Unit cost of a cell phone on the company’s balance sheet for external reporting:

The value of inventory per unit for external reporting purposes would be based on absorption costing, wherein the production cost per unit would include the allocated portion of fixed cost.

Production cost per unit –

Direct materials                                  $50

Direct labor                                        $10

Variable manufacturing overhead     $40

Fixed manufacturing overhead          $30

Total production cost per unit            $130

Hence, the value of inventory per unit for external reporting purposes is $130.

2. Determination of the increase or decrease in operating income when the selling price is reduced to $200 per phone:

Revised estimates –

Selling price = $200

Increase in sales volume = 20%

Revised sales units = 100,000 + 20% of 100,000 = 120,000 phones

Variable cost per phone –

Direct materials    $50

Direct labor           $10

Variable MOH      $40

Variable selling     $15

Total Variable cost $115

Contribution margin per phone = 200 – 115 = $85 per phone

Contribution margin total = $10,200,000

Original contribution margin = per unit = $250 – 115 = $135

Original contribution margin = $135 x 100,000 = $13,500,000

Difference in contribution margins = 13,500,000 – 10,200,000 = $3,300,000

Hence the operating income would also decrease by $3,300,000 as the fixed cost total of $4,000,000 would remain same for the original and proposed alternative.

Fixed cost –

Manufacturing OH            $3,000,000      ($40 x 100,000 units)

Selling costs                     $1,000,000      ($10 x 100,000 units)

Total fixed cost                 $4,000,000

000

Hence, the operating profit decreases by $3,300,000 when the selling price is reduced to $200 per phone, despite an increase of 20% in sales units.

1. Determination of the increase or decrease in monthly operating income as a result of the special order from Service Provider Company:

The monthly operating income would increase by $1,000,000 as a result of taking the order.

Explanation: SP Company pays for the manufacturing costs for 10,000 cell phones plus a profit of $100 per phone, which equals to $1,000,000. Since the company has excess capacity, fixed costs are not relevant in evaluating the order any revenue above the manufacturing costs is an increase in profit.

Computations:

Order = 10,000 phones per month

Manufacturing costs –

Manufacturing costs for 10,000 cell phones:
direct materials at $50 each	$500,000
Direct labor at $10	$100,000
variable overhead at $40 each	$400,000
total variable costs	$1,000,000

The entire $1,000,000 manufacturing costs are borne by the Service Provider Company.

Hence, $1,000,000 profit received from SP Company is an increase to the monthly income.