11-34 Special order, short-run pricing. GamesAhoy Corporation produces cricket bats for kids that it sellsfor $36 each. At capacity, the company can produce 50,000 bats a year. The costs of producing and selling 50,000 bats are as follows: Direct materials Direct manufacturing labor Variable manufacturing overhead Fixed manufacturing overhead Variable selling expenses Fixed selling expenses Total costs Cost per Bat $13 5 2 6 3 2 $31 Total Costs $ 650,000 250,000 100,000 300,000 150,000 100,000 $1,550,000 Required: 1. Suppose GamesAhoy is currently producing and selling 40,000 bats. At this level of production and sales,its fixed costs are the same as given in the preceding table. FieldTactics Corporation wants to place a one-time special order for 10,000 bats at $23 each. Slugger will incur no variable selling costs for thisspecial order. Should GamesAhoy accept this one-time special order? Show your calculations. 2. Now suppose GamesAhoy gger is currently producing and selling 50,000 bats. If GamesAhoy accepts FieldTactics’ offer it will have to sell 10,000 fewer bats to its regular customers. (a) On financial considerations alone, should GamesAhoy accept this one-time special order? Show your calculations. (b) On financial considerations alone, at what price would GamesAhoy be indifferent between accepting the special order and continuing to sell to its regular customers at $36 per bat. (c) What other factors should GamesAhoy consider in deciding whether to accept the one-time special order? (20 min.) Special order, short-run pricing 1. Revenues from special order ($23 10,000 bats) Variable manufacturing costs ($20110,000 bats) Increase in operating income if Bench order accepted $230,000 (200,000) $ 30,000 1 Direct materials cost per unit + Direct manufacturing labor cost per unit + Variable manufacturing overhead cost per unit = $13 + $5 + $2 = $20 GamesAhoy should accept FieldTactics’ special order because it increases operating income by $30,000. Because no variable selling costs will be incurred on this order, this cost is irrelevant. Similarly, fixed costs are irrelevant because they will be incurred regardless of the decision. $230,000 2a. Revenues from special order ($23 10,000 bats) Variable manufacturing costs ($20 10,000 bats) (200,000) Contribution margin foregone ([$36─$231] 10,000 bats) (130,000) Decrease in operating income if Bench order accepted $(100,000) 1 Direct materials cost per unit + Direct manufacturing labor cost per unit + Variable manufacturing overhead cost per unit + Variable selling expense per unit = $13 + $5 + $2 + $3 = $23 Based strictly on financial considerations, GamesAhoy should reject FieldTactics’ special order because it results in a $100,000 reduction in operating income. 2b. GamesAhoy will be indifferent between the special order and continuing to sell to regular customers if the special order price is $33. At this price, GamesAhoy recoups the variable manufacturing costs of $200,000 and the contribution margin given up from regular customers of $130,000 ([$200,000 + $130,000] ÷ 10,000 units = $33). That is, at the special order price of $33, Slugger recoups the variable cost per unit of $20 and the contribution margin per unit given up from regular customers of $13 per unit. An alternative approach is to recognize that GamesAhoy needs to earn $100,000 more than the revenues of $230,000 in requirement 2a, so that the decrease in operating income of $100,000 becomes $0. GamesAhoy will be indifferent between the special order and continuing to sell to regular customers if revenues from the special order = $230,000 + $100,000 = $330,000 or $33 per bat ($330,000  10,000 bats) Looked at a different way, GamesAhoy needs to earn the full price of $36 less the $3 saved on variable selling costs. 2c. GamesAhoy may be willing to accept a loss on this special order if the possibility of future long-term sales seem likely at a higher price. Moreover, GamesAhoy should also consider the negative long-term effect on customer relationships of not selling to existing customers. GamesAhoy cannot afford to sell bats to customers at the special order price for the long term because the $23 price is less than the full manufacturing cost of the product of $31. This means that in the long term, the contribution margin earned will not cover the fixed costs and result in a loss. GamesAhoy will then be better off shutting down. 11-35 Short-run pricing, capacity constraints. Fashion Fabrics makes pants from a special material. The fabric is special because of the way it fits many body types. The pants sell for $142. A well-known retail establishment has asked Fashion Fabrics to produce 3,000 shorts from the same fabric. The factory has unused capacity, so Barbara Brooks, the owner of Fashion Fabrics, calculates the cost of making a pair of shorts from the fabric. Costs for the pants and shorts are as follows: Required: 1. Suppose Fashion Fabrics can acquire all the fabric that it needs. What is the minimum price the company should charge for the shorts? 2. Now suppose that the fabric is in short supply. Every yard of fabric Fashion Fabrics uses to make shorts will reduce the pants that it can make and sell. What is the minimum price the company should charge for the shorts? SOLUTION (15-20 min.) Short-run pricing, capacity constraints. 1. Per pair of shorts: Fabric (3 yards $12 per yard) Variable direct manufacturing labor Variable manufacturing overhead Fixed manufacturing cost allocated Total manufacturing cost $36 10 4 9 $59 If Fashion Fabrics can get all the fabric it needs and has sufficient production capacity, then the minimum price it should charge per pair of shorts is the variable cost per pair of shorts = $36 + $10 + $4 = $50 per pair of shorts. 2. If the fabric is in short supply, then the fabric used for 2 shorts displaces 1 pant (6 yards of fabric per pant versus 3 yards of fabric per short). We calculate the contribution margin per pair of pants = Selling price – Variable costs = $142 − $100a = $42 a Direct materials, $72 + Variable direct manufacturing labor, $20 + Variable manufacturing overhead, $8 Pants require 6 yards of fabric so the contribution margin per unit of the constrained resource is $42 ÷ 6 yards = $7 per yard The minimum price Fashion Fabrics should charge for a pair of shorts is the variable cost per pair of shorts plus the contribution margin from 3 yards of fabric, or, $50 + (3 $7 per yard) = $71 per pair of shorts That is, if fabric is in short supply, Fashion Fabrics should not agree to produce any shorts unless the buyer is willing to pay at least $71 per pair of shorts. Another way to calculate the opportunity cost of producing a pair of shorts is to recognize that every time Fashion Fabrics uses fabric to produce a pair of shorts, it gives up the opportunity to produce 0.5 pants. So, Opportunity cost of a pair of shorts = 0.5 × Contribution margin from producing a pair of pants = 0.5 × $42 = $21. The minimum price Fashion Fabrics should charge for a pair of shorts is the variable cost per pair of shorts plus the opportunity cost of not producing 0.5 pants = $50 + $21 = $71. 11-36 International outsourcing. Cuddly Critters, Inc., manufactures plush toys in a facility in Queensland, Brisbane. Recently, the company designed a group of collectible resin figurines to go with the plush toy line. Management is trying to decide whether to manufacture the figurines themselves in existing space in the Queensland facility or to accept an offer from a manufacturing company in Indonesia. Data concerning the decision are: Expected annual sales of figurines (in units) Average selling price of a figurine Price quoted by Indonesian company, in Indonesian Rupiah (IDR), for each figurine Current exchange rate Variable manufacturing costs Incremental annual fixed manufacturing costs associated with the new product line Variable selling and distribution costsa Annual fixed selling and distribution costsa 400,000 $5 27,300 IDR 9,100 IDR = $1 $2.85 per unit $200,000 $0.50 per unit $285,000 a Selling and distribution costs are the same regardless of whether the figurines are manufactured in Cleveland or imported. 1. Should Cuddly Critters manufacture the 400,000 figurines in the Queensland facility or purchase themfrom the Indonesian supplier? Explain. 2. Cuddly Critters believes that the dollar may weaken in the coming months against the Indonesian rupiah and does not want to face any currency risk. Assume that Cuddly Critters can enter into a forward contract today to purchase 27,300 IDRs for $3.40. Should Cuddly Critters manufacture the 400,000 figurines in the Queensland facility or purchase them from the Indonesian supplier? Explain. 3. What are some of the qualitative factors that Cuddly Critters should consider when deciding whetherto outsource the figurine manufacturing to Indonesia? SOLUTION (20 min.) 1. International outsourcing. 27,300 IDR $3 . 9,100 IDR/$ Cost of purchasing 400,000 figurines from Indonesian supplier = $3 400,000 figurines = $1,200,000. Cost to purchase each figurine from Indonesian supplier = Costs of = Variable  Quantity of + Incremental fixed manufacturing figurines in Cleveland facility manufacturing cost per unit figurines produced manufacturing costs = ($2.85  400,000 units) + $200,000 = $1,340,000 Variable and fixed selling and distribution costs are irrelevant because they do not differ between the two alternatives of purchasing the figurines from the Indonesian supplier or manufacturing the figurines in Queensland. Cuddly Critters should purchase the figurines from the Indonesian supplier because the cost of $1,200,000 is less than the relevant cost of $1,340,000 to manufacture the figurines in Cleveland. 2. If Cuddly Critters enters into a forward contract to purchase 27,300 IDRs for $3.40, each figurine acquired from the Indonesian supplier will cost $3.40. Total cost of purchasing 400,000 figurines from Indonesian supplier = $3.40  400,000 figurines = $1,360,000. Cost of manufacturing 400,000 figurines in Queensland (see requirement 1) = $1,340,000. As in requirement 1, selling and distribution costs are irrelevant. Cuddly Critters should manufacture the figurines in Queensland because the relevant cost of $1,340,000 to manufacture the figurines in Queensland is less than the cost of $1,360,000 to enter into the forward contract and purchase the figurines from the Indonesian supplier. 3. In deciding whether to purchase figurines from the Indonesian supplier, Cuddly Critters should consider factors such as (a) quality, (b) delivery lead times, (c) fluctuations in the value of the Indonesian Rupiah relative to the dollar, and (d) the negative public and media reaction to not providing jobs in Queensland and instead supporting job creation in Indonesia. 11-37 Relevant costs, opportunity costs. Gavin Martin, the general manager of Oregano Software, must decide when to release the new version of Oregano’s spreadsheet package, Easyspread 2.0. Development of Easyspread 2.0 is complete; however, the diskettes, compact discs, and user manuals have not yet been produced. The product can be shipped starting July 1, 2017. The major problem is that Oregano has overstocked the previous version of its spreadsheet package, Easyspread 1.0. Martin knows that once Easyspread 2.0 is introduced, Oregano will not be able to sell any more units of Easyspread 1.0. Rather than just throwing away the inventory of Easyspread 1.0, Martin is wondering if it might be better to continue to sell Easyspread 1.0 for the next three months and introduce Easyspread 2.0 on October 1, 2017, when the inventory of Easyspread 1.0 will be sold out. The following information is available: Development cost per unit for each product equals the total costs of developing the software product divided by the anticipated unit sales over the life of the product. Marketing and administrative costs are fixed costs in 2017, incurred to support all marketing and administrative activities of Oregano Software. Marketing and administrative costs are allocated to products on the basis of the budgeted revenues of each product. The preceding unit costs assume Easyspread 2.0 will be introduced on October 1, 2017. Required: 1. On the basis of financial considerations alone, should Martin introduce Easyspread 2.0 on July 1, 2017, or wait until October 1, 2017? Show your calculations, clearly identifying relevant and irrelevant revenues and costs. 2. What other factors might Gavin Martin consider in making a decision? SOLUTION (30 min.) Relevant costs, opportunity costs. 1. Easyspread 2.0 has a higher relevant operating income than Easyspread 1.0. Based on this analysis, Easyspread 2.0 should be introduced immediately: Relevant revenues Relevant costs: Manuals, diskettes, compact discs Total relevant costs Relevant operating income Easyspread 1.0 $165 Easyspread 2.0 $215 $ 0 $38 Reasons for other cost items being irrelevant are Easyspread 1.0  Manuals, diskettes—already incurred  Development costs—already incurred  Marketing and administrative—fixed costs of period Easyspread 2.0  Development costs—already incurred  Marketing and administration—fixed costs of period 0 $165 38 $177 Note that total marketing and administration costs will not change whether Easyspread 2.0 is introduced on July 1, 2017, or on October 1, 2017. 2. Other factors to be considered: a. Customer satisfaction. If 2.0 is significantly better than 1.0 for its customers, a customer-driven organization would immediately introduce it unless other factors offset this bias toward “do what is best for the customer.” b. Quality level of Easyspread 2.0. It is critical for new software products to be fully debugged. Easyspread 2.0 must be error-free. Consider an immediate release only if 2.0 passes all quality tests and can be supported fully by the salesforce. c. Importance of being perceived to be a market leader. Being first in the market with a new product can give Oregano Software a “first-mover advantage,” e.g., capturing an initial large share of the market that, in itself, causes future potential customers to lean toward purchasing Easyspread 2.0. Moreover, by introducing 2.0 earlier, Oregano can get quick feedback from users about ways to further refine the software while its competitors are still working on their own first versions. Moreover, by locking in early customers, Oregano may increase the likelihood of these customers also buying future upgrades of Easyspread 2.0. d. Morale of developers. These are key people at Oregano Software. Delaying introduction of a new product can hurt their morale, especially if a competitor then preempts Oregano from being viewed as a market leader. 11-38 Opportunity costs and relevant costs. Jason Wu operates Exclusive Limousines, a fleet of 10 limousines used for weddings, proms, and business events in Washington, D.C. Wu charges customers a flat fee of $250 per car taken on contract plus an hourly fee of $80. His income statement for May follows: All expenses are fixed, with the exception of driver wages and benefits and fuel costs, which are both variable per hour. During May, the company’s limousines were fully booked. In June, Wu expects that Exclusive Limousines will be operating near capacity. Shelly Worthington, a prominent Washington socialite, has asked Wu to bid on a large charity event she is hosting in late June. The limousine company she had hired has canceled at the last minute, and she needs the service of five limousines for four hours each. She will only hire Exclusive Limousines if they take the entire job. Wu checks his schedule and finds that he only has three limousines available that day. Required: 1. If Wu accepts the contract with Worthington, he would either have to (a) cancel two prom contracts each for one car for six hours or (b) cancel one business event for three cars contracted for two hours each. What are the relevant opportunity costs of accepting the Worthington contract in each case? Which contract should he cancel? 2. Wu would like to win the bid on the Worthington job because of the potential for lucrative future business. Assume that Wu cancels the contract in requirement 1 with the lowest opportunity cost, and assume that the three currently available cars would go unrented if the company does not win the bid. What is the lowest amount he should bid on the Worthington job? 3. Another limousine company has offered to rent Exclusive Limousines two additional cars for $300 each per day. Wu would still need to pay for fuel and driver wages on these cars for the Worthington job. Should Wu rent the two cars to avoid canceling either of the other two contracts? SOLUTION (30 min.) Opportunity costs and relevant costs 1. If Wu cancels the two prom contracts, the opportunity cost of accepting the Worthington job would be $886.40, as follows: Lost revenue (2 × $250) + (12 hrs. × $80) $1,460.00 Less variable costs Driver wages and benefits* ($35 × 12 hrs.) 420.00 Fuel costs** ($12.80 × 12 hrs.) 153.60 Opportunity cost $ 886.40 *Driver wages and benefits are $35/hour ($43,750 ÷ 1,250 hours) ** Fuel costs are $12.80/hour ($16,000 ÷ 1,250 hours) If Wu cancels the business event contract, the opportunity cost would be $943.20, as follows: Lost revenue (3 × $250) + (6 hrs. × $80) Less variable costs Driver wages and benefits* ($35 × 6 hrs.) Fuel costs** ($12.80 × 6 hrs.) Opportunity cost $1,230.00 210.00 76.80 $ 943.20 *Driver wages and benefits are $35/hour ($43,750 ÷ 1,250 hours) ** Fuel costs are $12.80/hour ($16,000 ÷ 1,250 hours) Wu should cancel the prom contracts because the opportunity cost would be lower by $56.80 ($943.20 – $886.40). 2. If Wu cancels the two prom contracts, opportunity cost equals $886.40. In addition, variable costs of the 20-hour Worthington job would be (20 hrs. × $35) + (20 hrs. × $12.80) = $956. Therefore, the minimum amount Wu would bid is $1,842.40 ($886.40 + $956). 3. Yes, it would be in Wu’s best interest to lease the additional cars for a total of $600 because it is less than the opportunity cost of $886.40. 11-39 Opportunity costs. (H. Schaefer, adapted) The Wild Orchid Corporation is working at full production capacity producing 13,000 units of a unique product, Everlast. Manufacturing cost per unit for Everlast is: Manufacturing overhead cost per unit is based on variable cost per unit of $8 and fixed costs of $78,000 (at full capacity of 13,000 units). Marketing cost per unit, all variable, is $4, and the selling price is $52. A customer, the Apex Company, has asked Wild Orchid to produce 3,500 units of Stronglast, a modification of Everlast. Stronglast would require the same manufacturing processes as Everlast. Apex has offered to pay Wild Orchid $40 for a unit of Stronglast and share half of the marketing cost per unit. Required: 1. What is the opportunity cost to Wild Orchid of producing the 3,500 units of Stronglast? (Assume that no overtime is worked.) 2. The Chesapeake Corporation has offered to produce 3,500 units of Everlast for Wild Orchid so that Wild Orchid may accept the Apex offer. That is, if Wild Orchid accepts the Chesapeake offer, Wild Orchid would manufacture 9,500 units of Everlast and 3,500 units of Stronglast and purchase 3,500 units of Everlast from Chesapeake. Chesapeake would charge Wild Orchid $36 per unit to manufacture Everlast. On the basis of financial considerations alone, should Wild Orchid accept the Chesapeake offer? Show your calculations. 3. Suppose Wild Orchid had been working at less than full capacity, producing 9,500 units of Everlast, at the time the Apex offer was made. Calculate the minimum price Wild Orchid should accept for Stronglast under these conditions. (Ignore the previous $40 selling price.) SOLUTION (20 min.) Opportunity costs. 1. The opportunity cost to Wild Orchid of producing the 3,500 units of Stronglast is the contribution margin lost on the 3,500 units of Everlast that would have to be forgone, as computed below: Selling price Variable costs per unit: Direct materials Direct manufacturing labor Variable manufacturing overhead Variable marketing costs Contribution margin per unit Contribution margin for 3,500 units ($28  3,500 units) $ $10 2 8 4 52 24 $ 28 $98,000 The opportunity cost is $98,000. Opportunity cost is the maximum contribution to operating income that is forgone (rejected) by not using a limited resource in its next-best alternative use. 2. Contribution margin from manufacturing 3,500 units of Stronglast and purchasing 3,500 units of Everlast from Chesapeake is $105,000, as follows: Manufacture Stronglast Selling price Variable costs per unit: Purchase costs Direct materials Direct manufacturing labor Variable manufacturing costs Variable marketing overhead Variable costs per unit Contribution margin per unit Contribution margin from selling 3,500 units of Stronglast and 3,500 units of Everlast ($18  3,500 units; $12  3,500 units) $ 40 $ – 10 2 8 2 22 18 $63,000 Purchase Everlast $ Total 52 36 $ 4 40 12 $42,000 $105,000 As calculated in requirement 1, Wild Orchid’s contribution margin from continuing to manufacture 3,500 units of Everlast is $98,000. Accepting the Apex Company and Chesapeake offer will benefit Wild Orchid by $7,000 ($105,000 – $98,000). Hence, Wild Orchid should accept the Apex Company and Chesapeake Corporation’s offers. 3. The minimum price would be any price greater than $22, the sum of the incremental costs of manufacturing and marketing Stronglast as computed in requirement 2. This follows because, if Wild Orchid has surplus capacity, the opportunity cost = $0. For the short-run decision of whether to accept Apex’s offer, fixed costs of Wild Orchid are irrelevant. Only the incremental costs need to be covered for it to be worthwhile for Wild Orchid to accept the Apex offer.