Answer to Question #244404 in Management for Bili

Question

Great Company manufactures 60, 000 units of part XL-40 each year for use on its production line. The following are the costs of making part XL-40: Direct material Total Costs 60, 000 units Br. 480, 000 Cost per unit Br.8 Direct labor 360, 000 6 Variable factory overhead (FOH) 180, 000 3 Fixed FOH 360, 000 6 Total manufacturing costs Br. 1, 380, 000 Br.23 Another manufacturer has offered to sell the same part to Great for Br.21 each. The fixed overhead consists of depreciation, property taxes, insurance, and supervisory salaries. The entire fixed overhead would continue if the Great Company bought the component except that the cost of Br. 120, 000 pertaining to some supervisory and custodial personnel could be avoided. Instructions: a) Should the parts be made or bought? Assume that the capacity now used to make parts internally will become idle if the pats are purchased? b) Assume that the capacity now used to make parts will be either (i) be rented to nearby manufacturer for Br. 60, 000 for the year

Answer 1

At first glance, it appears unprofitable for Kora to accept the special order. Not only is the sales price of Br.100 per unit much less than the regular sales price, it is even less than Kora’s Br.102 average per-unit cost of manufacturing the product. Let us look, however, at the incremental monthly revenue and manufacturing costs that should result from accepting this special order

This analysis shows that accepting the special order will generate incremental revenue of Br.400, 000, and incremental costs of only Br.378, 000. Therefore, accepting the special order will increase Kora’s monthly profit by Br.22, 000.

The relevant factors in this type of decision are the incremental revenue that will be earned and the additional (incremental costs) that will be incurred by accepting the special order. The only incremental costs of filling the special order are the related variable manufacturing costs; accepting the order will not increase fixed manufacturing costs. Thus, the Br.102” average manufacturing cost,” which includes fixed costs per unit, is not entirely relevant to the decision.

Recommendation: The accountant’s role in decision-making is primarily that of a technical expert on cost analysis, i.e., collecting and reporting relevant information. However, many managers want the accountant to recommend the proper decision; the final choice always rests with the operating executives.

Based on the relevant data, Kora Company should accept the special order because it brings an additional income of Br. 22,000 for the company.