Heath Production manufactures chairs. Several weeks ago, the company received an

Question

Heath Production manufactures chairs. Several weeks ago, the company received an enquiry from Rose Limited. Rose wants to market a foldable chair similar to one of Heath's, and has offered to purchase 11,000 units if the offer can be completed in three months. The cost data for Heath's foldable chair is as follow: Direct material Direct labor (0.125@$36 per hour) Total manufacturing overhead Total The normal selling price of Heath's foldable chair is $53.00. However, Rose has offered Heath only $31.50 because of the large quantity it is willing to purchase. Rose requires a modification of the design that will allow a $4.20 reduction in direct material cost. The production manager of Heath notes that the company will incur $7400 in additional setup costs and will have to purchase a $4800 special equipment to manufacturing the unit for Rose. The equipment will be discarded once the special order is completed. Total manufacturing overhead costs are applied to production at the rate of $40 per machine hour. The figure is based, in part, on budgeted annual fixed overhead of $1,500,000 and planned production activity of 60,000 machine hours (5000 per month) Rose will allocate $3600 of existing fixed administrative costs to the order as part of the cost of doing business". REQUIREID a) Assume that Heath's present sales will not be affected by the special order $16.40 4.50 20.00 $40.90 should the order be accepted from the financial point of view? Show calculation. b) Assume that Hearth's current production activity 70 per cent of planned machine hours, can the company accept the order and meet Rose's deadline? c) Are allocated joint processing costs relevant when making a decision about whether to either sell a joint product at the split-off point or to process it further? Explain.

Explanation / Answer

a) Sales revenue from the Rose order = 11000*31.50 = 346500 Variable cost = 11000*(16.40-4.20+4.50) = 183700 Additional set up costs 7400 Cost of special equipment 4800 Increase in operating profits if the order is accepted 150600 The special order should be accepted as it increases the operating profits by $150,600 b) Three months normal machine hours for Heath = 5000*3 = 15000 Production possible in units = 15000/0.50 = 30000 Current production in units = 30000*70% = 21000 Spare capacity = 30000-21000 = 9000 Normal sales units lost if special order is accepted =11000-9000 = 2000 If the special order is accepted, the increase in net operating 150600 profit would be: Operating profits from the special order as at [a] Loss of contribution from reductipn in existing sales = 2000*(53-16.40-4.50) = 64200 Net increase in operating profits, if special order is accepted 86400 The company can accept the offer as the net increase in operating profits is positive and the order can be completed in 3 months time by foregoing current market sales to the extent of 2000 units. c) Allocated joint costs are not relevant for deciding on further processing of joint products, as the joint cost is a sunk cost beyond the split off point. What is relevant is the incremental processing costs after split off point and incremental revenues after the split off point. If the incremental revenues exceed the incremenal costs, further processing can be undertaken for the product.

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