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Question 4 Part AOld Navy Vineyard produces premium wine. Its success in the industry is due to its quality although all its customers, wine shops, and specialty grocery stores, are very cost conscious and negotiate for price cuts on all large orders. Noting that the wine industry is becoming increasingly competitive, Old Navy is looking for a way to meet the challenge. It is negotiating with Eastern Seasons, a regional specialty grocery store, regarding a large order of wine. Old Navy is currently producing at under-capacity and would like to keep its production facilities going, gaining better economies of scale by increasing production. Eastern Seasons has agreed to a large order (2,000 bottles), but only at a price of $40 per bottle. The special order can be produced in one batch with available capacity. Old Navy gathered the following information: Next month's budgeted operating information (based on 10,000 units/month, and a normal batch size of 1,000 bottles). Special order information (order is produced in one batch of 2,000 bottles): Regular sales price (per bottle) $ 55 Variable manufacturing costs Batch-level costs (incurred with each batch produced) Fixed manufacturing costs Fixed marketing costs Special order information (order is produced in one batch of 2,000 bottles): Units (bottles) Selling price per bottle 2,000 $ 40 No variable marketing costs would be associated with the special order, but Old Navy has spent $2,500 during the past two months trying to get Eastern Seasons to execute a deal. Required: a) How much will the special order change Old Navy's total operating income? b) How much would the special order change Old Navy's total operating income if Old Navy is operating at full capacity and, if it accepted the order from Eastern Seasons, would lose the sale of 2,000 bottles to regular customers? (Assume that sales lost to normal customers would be produced in two batches of 1,000 bottles, while the special order as above could be produced in a single batch of 2,000 bottles.)

Answer 1

a) Additional Income by producing extra 2000 bottles -->

Sale price of 2000 bottles @ $40 = $80,000

Less: Variable Cost for 2000 bottles @ $ 22 = $44,000

Less: Batch cost for 2000 bottles ($6 * 1000) = $6,000

Additional Income = $30,000 Answer

Note: 1. The cost per unit is given for 1000 bottles, hence the total cost per batch will be 1000*6 i.e. $ 6,000 and as the batch cost is incurred per batch, the total cost will remain the same for producing 2000 bottles in one batch.

2. No fixed manufacturing and selling cost would be incurred as these costs are fixed and not increased as a result of increase in production.

3. $2,500 spent is a sunk cost and should not be considered while making the decisions.

b) Change in total operating income as a result of Special order, if company is operating at full capacity -->

Normal sales value of 2000 bottles @ $55 per bottle = $110,000

Less: Variable Cost for 2000 bottles @ $ 22 = $44,000

Less: Batch cost for 2000 bottles produced in 2 batches ($6000*2) = $12,000

Total contribution on normal sale of 2000 bottles (A) = $54,000

Total contribution on special sale of 2000 bottles (B) - from above = $30,000

Decrease in operating income (A-B) = $24,000 Answer

Notes: 1.If bottles are produced in normal course, it is produced in a batch of 1000 bottles. The cost of one batch production is $6,000 and hence cost for producing 2000 bottles would be twice i.e. $12,000.