Chapter 4, Problem 41E

Special Order

Fairmount Travel Gear produces backpacks and sells them to vendors who sell them under their own label. The cost of one of its backpacks follows:

Riverside Discount Mart, a chain of low-price stores, has asked Fairmount to supply it with 3,000 backpacks for a special promotion Riverside is planning. Riverside has offered to pay Fairmount a unit price of $63 per pack. The regular selling price is $90. The special order would require some modification to the basic model. These modifications would add $6.00 per unit in material cost, $2.50 per unit in labor cost, and $0.70 in variable overhead cost. Although Fairmount has the capacity to produce the 3,000 units without affecting its regular production of 45,000 units, a onetime rental of special testing equipment to meet Riverside’s requirements would be needed. The equipment rental would be $7,500 and would allow Fairmount to test up to 5,000 units.

Required

1. a.      Prepare a schedule to show the impact of filling the Riverside order on Fairmont’s profits for the year.
2. b.      Would you recommend that Fairmont accept the order?
3. c.       Considering only profit, determine the minimum quantity of backpacks in the special order that would make it profitable.

To determine

Calculate the impact on operating profit because of the special order.

Answer to Problem 41E

The operating profit decreases by $3,600 because of the special order of 3,000 backpacks.

Explanation of Solution

Operating profit: The operating profit is the excess of total revenues over total expenses after adjusting for depreciation and taxes.

• • A special order has a price of $63 and 3,000 units (backpacks).
• • Fixed cost for special order will increase by $7,500 because of rental equipment.
• • Special order will require the additional material cost of $6, the labor cost of $2.5 and variable cost of$0.70.

Compute the impact on operating profit because of the special order:

Particulars	Status Quo: 45,000 units	Alternative: 48,000 units	Difference
Sales revenue	$4,050,000	$4,239,000(1)	$189,000 higher
Less: material	$1,215,000	$1,314,000(2)	$99,000 higher
Labor	$810,000	$871,500(3)	$61,500 higher
Variable cost	$337,500	$362,100(4)	$24,600 higher
Total variable overhead	$2,362,500	$2,547,600	$185,100 higher
Contribution margin	$1,687,500	$1,691,400	$3,900 higher
Less: fixed overhead	$405,000	$412,500(5)	$7,500 higher
Operating profit	$1,282,500	$1,278,900	$3,600 lower

Table: (2)

Thus, the operating profit decreases by $3,600 because of the special order of 3,000 backpacks.

Working note 1:

Compute the sales revenue for an alternative:

$\begin{array}{c}\text{Sales}\text{revenue}=\text{Status}\text{quo}\text{sales}+(\text{Special}\text{order}\times \text{sale}\text{price}\text{(unit))}\\ \text{=}\text{\$4,050,000}\text{+}30\text{00}\times \$63\\ =\$4,239,000\end{array}$

Working note 2:

Compute the material cost for the alternative:

$\begin{array}{c}\text{Material}\text{cost}=\text{Status}\text{quo}\text{material}\text{cost}+\\ (\text{Special}\text{order}\times \text{Special}\text{order}\text{material}\text{cost(unit))}\\ \text{=}\text{\$1,215,000}\text{+}(3,0\text{00}\times \$33(6))\\ =\$1,314,000\end{array}$

Working note 3:

Compute the labor cost for the alternative:

$\begin{array}{c}\text{labor}\text{cost}=\text{Status}\text{quo}\text{labor}\text{cost}+\\ (\text{Special}\text{order}\times \text{Special}\text{order}\text{labor}\text{cost(unit))}\\ \text{=}\text{\$810,000}\text{+}(3,0\text{00}\times \$20.5(6))\\ =\$871,500\end{array}$

Working note 4:

Compute the variable cost for the alternative:

$\begin{array}{c}\text{Variable}\text{cost}=\text{Status}\text{quo}\text{variable}\text{cost}+\\ (\text{Special}\text{order}\times \text{Special}\text{order}\text{variable}\text{cost(unit))}\\ \text{=}\text{\$337,500}\text{+}(3,0\text{00}\times \$8.2(6))\\ =\$362,100\end{array}$

Working note 5:

Compute the fixed cost for the alternative:

$\begin{array}{c}\text{Fixed}\text{cost}=\text{Status}\text{quo}\text{fixed}\text{cost}+\text{Additional}\text{fixed}\text{cost}\\ \text{=}\text{\$405,000}\text{+}\$7,500\\ =\$412,500\end{array}$

Working note 6:

Compute the revised costs:

Particulars	Amount	Additional cost	Total
Material cost	$27	$6.0	$33
Labor	$18	$2.5	$20.5
Variable overhead	$7.5	$0.7	$8.2

Table: (6)

To determine

Recommend whether Company F should accept the offer or not.

Explanation of Solution

Company F should not accept the offer. The operating profit decreases by $3,600 because of the special order of 3,000 backpacks. Accepting the offer will decrease the operating profit by $3,600.

Thus, Company F should not accept the offer as per the loss of the operating profit.

To determine

Considering only the profit, determine the minimum quantity of backpacks in the special order that would make it profitable, assuming capacity is available.

Answer to Problem 41E

Company F should sell 5,769 units in order to make the business profitable.

Explanation of Solution

Breakeven point (BEP): The breakeven point or BEP is that level of output at which the total revenue is equal to the total cost. The BEP means there are no operating income and no operating losses. The management keeps an eye on the breakeven point in order to avoid the operating losses in order to avoid losses.

Contribution margin: The excess of sales price over the variable expenses is referred to as the contribution margin. It is computed by deducting the variable expenses from the sales revenue.

Company F should use the break-even analysis to find out the minimum quantity of backpacks in the special order that would make it profitable. Total variable cost is $61.7$\$33(\text{material}\text{cost)}, \$20.5(\text{labor)}\text{and }\$8.2(\text{variable}\text{overhead)}$. Fixed cost increases by $7,500.

Compute the break-even point:

$\begin{array}{c}\text{Break-even}\text{point}\text{=}\frac{\text{Fixed}\text{cost}}{\text{Contribution}\text{margin}\text{(4)}}\\ =\frac{\$7,500}{\$1.3}\\ =5,769\text{units}\end{array}$

Thus, Company F should sell 5,769 units in order to make the business profitable.

Working note 4:

Compute the contribution margin:

$\begin{array}{c}\text{Contribution}\text{margin}\text{=}\text{Sales}\text{price}-\text{Variable}\text{cost}\\ =\$63-\$61.7\\ =\$1.3\end{array}$