Question

Andretti Company has a single product called a Dak. The company normally produces and sells 88,000 Daks each year at a selling price of $56 per unit. The company's unit costs at this level of activity are given below: Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Variable selling expenses Fixed selling expenses Total cost per unit $ 6.50 9.00 3.80 9.00 ($792,000 total) 2.70 4.50 ($396,000 total) $ 35.50 A number of questions relating to the production and sale of Daks follow. Each question is independent. Required: 1-a. Assume that Andretti Company has sufficient capacity to produce 114,400 Daks each year without any increase in fixed manufacturing overhead costs. The company could increase its unit sales by 30% above the present 88,000 units each year if it were willing to increase the fixed selling expenses by $150,000. What is the financial advantage (disadvantage) of investing an additional $150,000 in fixed selling expenses? 1-b. Would the additional investment be justified? 2. Assume again that Andretti Company has sufficient capacity to produce 114,400 Daks each year. A customer in a foreign market wants to purchase 26,400 Daks. If Andretti accepts this order it would have to pay import duties on the Daks of $3.70 per unit and an additional $23,760 for permits and licenses. The only selling costs that would be associated with the order would be $2.10 per unit shipping cost. What is the break-even price per unit on this order? 3. The company has 800 Daks on hand that have some irregularities and are therefore considered to be "seconds." Due to the irregularities, it will be impossible to sell these units at the normal price through regular distribution channels. What is the unit cost figure that is relevant for setting a minimum selling price? 4. Due to a strike in its supplier's plant, Andretti Company is unable to purchase more material for the production of Daks. The strike is expected to last for two months. Andretti Company has enough material on hand to operate at 25% of normal levels for the two-month period. As an alternative, Andretti could close its plant down entirely for the two months. If the plant were closed, fixed manufacturing overhead costs would continue at 35% of their normal level during the two-month period and the fixed selling expenses would be reduced by 20% during the two-month period. a. How much total contribution margin will Andretti forgo if it closes the plant for two months? b. How much total fixed cost will the company avoid if it closes the plant for two months? c. What is the financial advantage (disadvantage) of closing the plant for the two-month period? d. Should Andretti close the plant for two months?

Answer 1

Answer to Question 1:

Question 1-a Calculation of incremental net operating income Incremental units: 114,400 - 88,000 = 26,400 units Incremental Per unit Total Amount Calculation units Sales 26,400 $ 56.00 $ 1,478,400 (26,400 X 56.00) Variable costs: Direct materials 26,400 $ 6.50 $ 171,600 (26,400 X 6.50) Direct labor 26,400 $ 9.00 $ 237,600 (26,400 X 9.00) Variable manufacturing 26,400 $ 3.80 $ 100,320 overhead (26,400 X 3.80) Variable selling 26,400 $ 2.70 $ 71,280 expenses (26,400 X 2.70) Total variable costs 26,400 $ 22.00 $ 580,800 (1,478,400 - Contribution margin $ 897,600 580,800) Incremental Fixed $ 150,000 selling expenses Incremental net (897,600 - $ 747,600 operating income 150,000) Financial Advantage = $ 747,600 Question 1-b Since it results in incremental net operating income, the increase in fixed selling expenses is justified.

Answer to Question 2, 3, and 4-a:

Question 2 Calculate the break even price as follows: Sales - variable costs = Fixed costs (26,400 X sales price per unit) - (26,400 X (6.50 +9.00 +3.80 +3.70 + 2.10)) = $ 23,760 26,400 X sales price per unit = 23,760 +662,640 26,400 X sales price per unit = 686,400 Break even sales price per unit = $26.00 Therefore, the break even sales price is $26.00 per unit. Question 3 The cost incurred for manufacturing is a sunk cost as it already has been incurred hence it is not relevant. Fixed selling expenses are not relevant because they will be incurred whether the units are sold or not. The variable selling cost = $ 2.70 is the relevant cost Question 4-a Contribution per unit lost = 56.00 - 22.00 = $34.00 Units lost = (88,000/12) X 2 months X 75% = 11,000 We get 75%, since it mentions it will be operating at 25% for two months, hence that means we will be losing 75% of our units sold for 2 months Total Contribution lost = 11,000 X 34.00 = $374,000

Answer to Question 4-b, 4-c and 4-d:

Question 4-b Total fixed manufacturing cost avoided = (792,000/12) X 2 months X 65% = 85,800 Total fixed selling cost avoided = (396,000/12) X2 X 20% = 13,200 Total fixed costs avoided = 85,800 + 13,200 = $99,000 $ -616,000 Question 4-c Decrease in sales (11,000 X 56) Decrease in variable expenses (11,000 X 22.00) Decrease in fixed costs Impact on profits $ 242,000 $ 99,000 $ -275,000 (-616,000 + 242,000+ 99,000) Calculation Therefore, due to shutdown of plant, it will lead to reduction profit of $275,000 Financial disadvantage = $275,000 Question 4-d The Company should not shutdown the plant, it should continue operating at 25% for two months, because if it shuts down, it will lead to a reduction in profit amounting to $275,000 hence to avoid the reduction of the profit, it should continue operating the plant at 25% capacity.

Answer to Question 5:

Question 5 The relevant cost are those that can be avoided by purchasing from outside manufacturer. These costs are: Variable manufacturing costs per unit $ 19.30 ($6.50 + $9 + 3.80) Fixed Manufacturing cost $ 2.70 ($792,000 X 30% = $237,600/88,000) Variable selling expenses $ 0.90 ($2.70 X 1/3) Total costs avoided $ 22.90 The avoidable cost per unit = $22.90 The outsider manufacturer quotation must be less than $ 22.90 per unit, to be acceptable for the company.