b) Prepare an income statement using the absorption approach (15 pts) Athletics

Question

b) Prepare an income statement using the absorption approach (15 pts) Athletics Inc. makes jerseys for teams. The NJIT Soccer Coach offers to buy 100 jerseys with the school logo on them for $15 each. The usual price for jerseys is $18, which is an 80% markup over the $10 price Athletics pays to buy them. Athletics prints logos on the jerseys at a variable cost of $2 per jersey, and the fixed costs for equipment and other expenses is $8,000. Athletics makes about 2,000 jerseys per year, so the fixed cost is about 4 per jersey. Athletics has excess capacity to make the special order, but the manager turned down the NJIT offer saying, "If we sell at $15 and our cost is $16, we lose money on each jersey we sell" a) Compute the amount by which the operating income of Athletics will change if it 6. accepted the NJIT offer b) Is the manager right, and why?

Explanation / Answer

Ans 1. In order to determine the change in operating income which includes the manager's order, we need to first determine the operating income for 2000 units sold.

ORIGINAL SCENARIO

SCENARIO WITH NJIT's ORDER (NEW SCENARIO)

Change will calculated as New Scenario minus Old Scenario

4300 - 4000 = 300

Ans 2. The manager is incorrect in this case because this is an incremental over and above the usual orders. The usual orders will continued to priced at $18 and at 100% capacity utilisation (i.e. 2000 units sold), Athletics will make a operating income of $2 each. This incremental order adds $300 to the operating income (as shown above) because the company benefits from operating leverage (i.e fixed costs remain the same) and will also improve the operating margin. In fact, even if the incremental order is of 1 unit, the company will still benefit in terms of operating income and margins rising ($15 - $10 - $2) = $3 (fixed cost is zero for this incremental order).

Another scenario where the manager sells all units at $15, he will have sell approximately 2667 units to breakeven. Lets look at the table below.

So the incremental order of only 100 units at $15, when all units have to be sold at $15, should be rejected.

Revenues (2000 units X $18) 36000 (-) COGS (2000 units X $10) 20000 Gross Profit 16000 (-) Fixed Cost 8000 (-) Variable Cost (2000 units X $2) 4000 Operating Income 4000

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