Chapter 12, Problem 18P

To determine

Relevant Cost: Relevant Costs pertain to costs that need to be incurred if a decision regarding producing a product in excess of normal capacity has to be taken. Thus, it ignores all unavoidable fixed costs, and costs which have to be incurred irrespective of whether excess units are produced until maximum capacity is exhausted. If maximum capacity is exhausted to produce the said units, they will become relevant costs.

Profitability of Production of units under different scenarios.

Answer to Problem 18P

Solution:

1. If the company sells 25% above 60000 units after incurring a fixed selling expense of $80000, the financial advantage of spending $80000 will be $130000. The additional investment would be justified, as the company is making $130000 more after considering the expense of $80000.
2. The break-even price on the order for exporting 20000 units to a customer in a foreign market place would be $22.15.
3. The Daks with irregularities can be sold at a minimum price of $18 per unit.
4. a)Andretti will forgo a contribution of $42000 if it closes the plant for 2 months.

b)Fixed Costs of $27000 will be avoided of the plant is closed for 2 months.

c)The financial disadvantage of closing the plant for 2 months will be $15000

d)The plant should operate ,as Andretti will incur a loss of $15000 more if plant is kept closed for 2 months.

5. Andretti’s avoidable cost per unit that it should compare with price quoted by outside manufacturer will be $20.95

Explanation of Solution

1. In order to find the financial advantage of producing 25% over 60000 units, the following steps will be required:

Finding variable cost per unit:

Direct Materials……………………………………………$10

Direct Labour………………………………………………$4.5

Variable Manufacturing Overheads……………………….$2.3

Variable Selling Expense………………………………….$1.2

Total Variable Expense…………………………….……...$18.

Finding Contribution per unit:

$ContributionPerUnit=Selling\mathrm{Pr}icePerUnit-VariableExpensePerUnit$

$\begin{array}{l}ContributionPerUnit=32-18\\ ContributionPerUnit=\$14\end{array}$

Finding Total Contribution if 25% units are produced over 60000:

$\begin{array}{l}No.OfUnits\mathrm{Pr}oduced=\frac{25}{100}*60000\\ No.OfUnits\mathrm{Pr}oduced=15000units\end{array}$

$\begin{array}{l}ContributionOf15000units=\$14*15000units\\ TotalContribution=\$210000\end{array}$

Finding Financial Advantage:

$\begin{array}{l}TotalContribution-FixedSellingExpense\\ 210000-80000\\ \$130000\end{array}$

2. In order to find Break Even Selling Price per unit to be quoted to customer in foreign market, the following steps will be used:

Variable Expenses to be incurred per unit:

Direct Materials……………………………………………$10

Direct Labour………………………………………………$4.5

Variable Manufacturing Overheads……………………….$2.3

Shipping Cost…………..………………………………….$3.2

Import Duty Per Unit………………………………………$1.7

Total Variable Expenses……………………………..……$21.70

Avoidable Fixed Cost for License………………………...$9000

Formula:

$\begin{array}{l}Contribution\mathrm{Re}quiredPerUnitToBreakEven=\frac{AvoidableFixed\mathrm{Cos}t}{No.OfUnitsToBeSold}\\ Contribution\mathrm{Re}quiredPerUnitToBreakEven=\frac{9000}{20000}\\ Contribution\mathrm{Re}quiredPerUnitToBreakEven=\$0.45\end{array}$

Therefore, Break Even Selling Price will be:

$\begin{array}{l}VariableExpensePerUnit+Contribution\mathrm{Re}quiredPerUnitToBreakEven\\ 21.70+0.45\\ \$22.15\end{array}$

3. In order to find minimum selling price of 1000 units that have some irregularities and have to be sold at a price lower than normal selling price, we would need to find variable cost per unit, Thus the minimum selling price will be the total variable cost per unit, as fixed costs are unavoidable and for given question we shall assume that variable selling costs have to be incurred to sell these items.

Finding variable cost per unit:

Direct Materials……………………………………………$10

Direct Labour………………………………………………$4.5

Variable Manufacturing Overheads……………………….$2.3

Variable Selling Expense………………………………….$1.2

Total Variable Expense…………………………….……...$18.

As discussed above the minimum selling price will be $18 per unit.

4. a)In order to find contribution forgone if plant is closed for 2 months, we will need to find operating capacity at 30% of normal level for 2 months as below:
$\begin{array}{l}NormalCapacityOfThePlant=60000UnitPerYear\\ NormalCapacityOfThePlant=60000/12i.e.5000UnitsPerMonth\\ NormalCapacityOfThePlantAt30\%for2Months=5000*\frac{30}{100}*2\\ NormalCapacityOfThePlantAt30\%for2Months=3000Units\end{array}$

Contribution per unit:

$ContributionPerUnit=Selling\mathrm{Pr}icePerUnit-VariableExpensePerUnit$

$\begin{array}{l}ContributionPerUnit=32-18\\ ContributionPerUnit=\$14\end{array}$

Contribution Forgone will be calculated as below:

Contribution Per Unit*UnitsProduced@30% Capacity for 2 months.

$14*3000Units

$42000

Foregone Contribution Margin is the difference between the actual margin and margin that could have been achieved. If the plant closes than the contribution margin will be nil. So, actual margin will be equal to forgone contribution margin.

b) Avoidable Fixed costs as given would be 40% of Fixed Manufacturing Overheads and 20% of Fixed Selling Overheads, Which will be arrived as below:

Fixed Manufacturing Overheads per year…………………………………$300000

Fixed Manufacturing Overheads per month(300000/12)………………....$25000

Fixed Manufacturing Overheads@40% for 2 Months(25000*2*0.4)...$20000 Fixed Selling Overheads per year…………………………………………$210000

Fixed Selling Overheads per month(210000/12)………………………….$17500

Fixed Selling Overheads@20% for 2 Months(17500*2*0.2)…………..$7000 Total Avoidable Fixed Cost(20000+7000)………………………………..$27000

c) Financial Disadvantage of closing the plant for 2 months will be as below:

Avoidable Fixed Costs-Contribution Forgone

$27000-$42000

$15000

d)The company should not shut down the plant as it will incur a loss of $15000 more.

5. In order to find avoidable costs per unit, we need to find variable costs that will be avoided if materials are brought from outside vendor:

Variable Expense:

Direct Materials……………………………………………$10

Direct Labour………………………………………………$4.5

Variable Manufacturing Overheads……………………….$2.3

Variable Selling Expense(1.2*1/3)……………….……….$0.4

Total Variable Expenses…………………………………..$17.2

Avoidable Fixed Cost(300000*75/100)…………………..$225000

Avoidable Fixed Cost per unit($225000/60000)……...….$3.75

Total Avoidable Cost per unit(17.2+3.75)………………..$20.95

Conclusion

Thus, decisions of further production can be taken with the help of finding which expenses are avoidable and unavoidable. Those which can be avoided are relevant costs.