Delta Company produces a single product. The cost of producing and selling a single unit of this product at the company’s normal activity level of 100,800 units per year is:

Delta Company produces a single product. The cost of producing and selling a single unit of this product at the company’s normal activity level of 100,800 units per year is:

Direct materials	$	1.50
Direct labor	$	3.00
Variable manufacturing overhead	$	0.80
Fixed manufacturing overhead	$	4.35
Variable selling and administrative expenses	$	1.40
Fixed selling and administrative expenses	$	2.00

The normal selling price is $18.00 per unit. The company’s capacity is 130,800 units per year. An order has been received from a mail-order house for 2,500 units at a special price of $15.00 per unit. This order would not affect regular sales or the company’s total fixed costs.

Required:

1. What is the financial advantage (disadvantage) of accepting the special order?

2. As a separate matter from the special order, assume the company’s inventory includes 1,000 units of this product that were produced last year and that are inferior to the current model. The units must be sold through regular channels at reduced prices. What unit cost is relevant for establishing a minimum selling price for these units?

Explanation

The financial advantage is computed as follows:

	Per Unit			2,500 Units
Incremental sales	$	15.00		$	37,500
Incremental costs:
Direct materials		1.50			3,750
Direct labor		3.00			7,500
Variable manufacturing overhead		.80			2,000
Variable selling and administrative		1.40			3,500
Total incremental costs	$	6.70			16,750
Financial advantage of accepting the special order		8.30			20,750

The fixed costs are not relevant to the decision because they will be incurred regardless of whether the special order is accepted or rejected.

2.

The relevant cost is $1.40 (the variable selling and administrative expenses). All other variable costs are sunk because the units have already been produced. The fixed costs are not relevant because they will not change in total as a consequence of the price charged for the left-over units.

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Han Products manufactures 39,000 units of part S-6 each year for use on its production line. At this level of activity, the cost per unit for part S-6 is:

Han Products manufactures 39,000 units of part S-6 each year for use on its production line. At this level of activity, the cost per unit for part S-6 is:

Direct materials	$	3.20
Direct labor		11.00
Variable manufacturing overhead		2.80
Fixed manufacturing overhead		12.00
Total cost per part	$	29.00

An outside supplier has offered to sell 39,000 units of part S-6 each year to Han Products for $23 per part. If Han Products accepts this offer, the facilities now being used to manufacture part S-6 could be rented to another company at an annual rental of $89,000. However, Han Products has determined that two-thirds of the fixed manufacturing overhead being applied to part S-6 would continue even if part S-6 were purchased from the outside supplier.

Required:

What is the financial advantage (disadvantage) of accepting the outside supplier’s offer?

Explanation

The costs that can be avoided as a result of purchasing from the outside are relevant in a make-or-buy decision. The analysis is:

	Per unit Differential Costs							39,000 Units
	Make			Buy				Make			Buy
Cost of purchasing				$	23						$	897,000
Cost of making:
Direct materials	$	3.20						$	124,800
Direct labor		11.00							429,000
Variable overhead		2.80							109,200
Fixed overhead		4.00	*						156,000
Total cost	$	21.00		$	23.00			$	819,000		$	897,000

* The remaining $8 of fixed overhead cost ($12.00 per unit × 2/3 = $8 per unit) would not be relevant, because it will continue regardless of whether the company makes or buys the parts.

The $89,000 rental value of the space being used to produce part S-6 is an opportunity cost of continuing to produce the part internally. Thus, the complete analysis is:

	Make			Buy
Total cost, as above	$	819,000		$	897,000
Rental value of the space (opportunity cost)		89,000
Total cost, including opportunity cost	$	908,000		$	897,000
Financial advantage accepting the outside supplier’s offer	$			11,000

The company would be $11,000 better off if it accepted the outside supplier’s offer.

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