Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 48

Special Orders

Sherene Nili manages a company that produces wedding gowns. She produces both a custom product that is made to order and a standard product that is sold in bridal salons. Her accountant prepared the following forecasted income statement for March, which is a busy month:

	Custom Dresses	Standard Dresses	Total
Number of dresses	10	20	30
Sales revenue	$50,000	$25,000	$75,000
Materials	$10,000	$ 8,000	$18,000
Labor	20,000	9,000	29,000
Machine depreciation	600	300	900
Rent	4,200	2,800	7,000
Heat and light	1,000	600	1,600
Other production costs			2,800
Marketing and administration			7,700
Total costs			$67,000
Operating profit			$ 8,000

Ms. Nili already has orders for the 10 custom dresses reflected in the March forecasted income statement. The depreciation charges are for machines used in the respective product lines. Machines depreciate at the rate of $1 per hour based on hours used, so these are variable costs. In March, cutting and sewing machines are expected to operate for 900 hours, of which 600 hours will be used to make custom dresses. The rent is for the building space, which has been leased for several years at $7,000 per month. The rent, heat, and light are allocated to the product lines based on the amount of floor space occupied.

A valued customer, who is a wedding consultant, has asked Ms. Nili for a special favor. This customer has a client who wants to get married in early April. Ms. Nili’s company is working at capacity and would have to give up some other business to make this dress. She can’t renege on custom orders already agreed to, but she can reduce the number of standard dresses produced in March to 10. Ms. Nili would lose permanently the opportunity to make up the lost production of standard dresses because she has no unused capacity for the foreseeable future. The customer is willing to pay $25,000 for the special order. Materials and labor for the order will cost $6,000 and $10,000, respectively. The special order would require 140 hours of machine time. Ms. Nili’s company would save 150 hours of machine time from the standard dress business given up. Rent, heat and light, and other production costs would not be affected by the special order.

Required

a. Should Ms. Nili take the order? Explain your answer.

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b. What is the minimum price Ms. Nili should accept to take the special order?

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c.What are the other factors, if any, besides price that she should consider?

Step 1 of 3

a. ?Based on profit, Ms. Nili should accept the special order. Accepting the special order means Ms. Nili will only be able to produce 10 standard dresses. Each standard dress requires 15 (= 300 hours ÷ 20 dresses) hours of machine time per dress. Because she is committed to the custom dresses (whether more profitable or not), she must cut back the number of standard dresses by 10. The rent, heat and light, and other production costs are fixed and will not be affected by this decision.

	Without Special Order		With  Special Order		Impact
Revenuea?	$??75,000		$??87,500		$ 12,500		increase
Materialsb?	18,000		20,000		2,000		increase
Laborc?	29,000		34,500		5,500		increase
Machine depreciationd?	900		890		10		decrease
?Contribution margin…?	$   27,100		$   32,110		$ 5,010		increase*
Rent?	7,000		7,000		0
Heat and light?	1,600		1,600		0
Other production costs?	2,800		2,800		0
Marketing and administration	7,700		7,700		0
Operating profit?	$?   8,000		$?13,010		$   5,010		increase*

* Note the equality.

a Additional revenues with the special order = $25,000 – [10 standard dresses x ($25,000 ÷ 20 dresses)].

b Additional materials with the special order = $6,000 – [10 standard dresses x ($8,000 ÷ 20 dresses)].

c Additional labor with the special order = $10,000 – [10 standard dresses x ($9,000 ÷ 20 dresses)].

d Reduced machine depreciation with the special order = $140 – $150. (Note the machine depreciation rate is $1 per hour.)

Alternative solution using differential analysis:

Additional revenue?	$12,500	=$25,000 –10 x ($25,000 ÷ 20)
Additional materials?	2,000	= $6,000 – 10 x ($8,000 ÷ 20)
Additional labor?	5,500	= $10,000 – 10 x ($9,000 ÷ 20)
Reduced machine depreciation?	(10)	= $140 – $150
Additional contribution margin…?	$   5,010