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30-07-2018

Product code: Accounting-QA259

During 2016, Spade Company, a manufacturer of men’s blue jeans, had manufactured 2.2 million pairs of jeans, which had been sold to various clothing wholesalers and department stores. Partway through the year, the president, Ruth Catone, died unexpectedly. Her son, Chuck, became the new president. Chuck had worked for 15 years in the marketing phases of the business but he had little experience with the accounting and manufacturing, which were his mother’s strengths.

Following are two versions of the 2016 income statement, first in standard financial reporting form and then in contribution form.  Both forms include totals and per unit amounts. Note that variable selling and administrative expenses consist of sales commissions, shipping expenses, and advertising allowances paid to customers based on units sold.

Income Statement

For Year Ended December 31, 2016

Total                  Per Unit

Sales                                                                    \$77,000,000               \$35.00

Less: Cost of Goods sold                                     46,200,000                 21.00

Gross Margin                                                        30,800,000                 14.00

Less: Selling and administrative expenses            28,600,000                 13.00

Operating income                                                 \$ 2,200,000                \$ 1.00

Contribution Form Income Statement

For the Year Ended December 31, 2016

Total                                       Per Unit

Sales                                                                       \$77,000,000                     \$35.00

Less variable expenses:

Manufacturing                         \$35,200,000

Selling & administrative            16,500,000         51,700,000                       23.50

Contribution margin                                               \$25,300,000                   \$  11.50

Less fixed expenses:

Manufacturing                       \$  11,000,000

Selling & administrative            12,100,000         23,100,000                       10.50

Operating income                                                   \$  2,200,000                     \$  1.00

Chuck has asked you to address two questions regarding the pricing of special orders.

1. (7 points)Near the end of 2016, I brought in a special order from Costco for 140,000 jeans at \$34 each. Costco agreed to cover all shipping expenses and there would be zero special advertising allowance for the order.  I said I’d accept a flat \$47,600 sales commission instead of the usual 5% of selling price, but my mother refused the order. She insisted on maintaining a rigid pricing policy, saying that it was bad business to accept orders for a price less than 165% of full manufacturing cost, which in this case would be 165% x 21.00/unit or \$34.65.

That policy bothered me. We had idle capacity. The way I figured, our manufacturing costs would go up by 140,000 ´ \$21 = \$2,940,000, but our selling and administrative expenses would go up by only my sales commission of \$47,600. That would mean additional operating income of 140,000 ´ (\$34 – \$21) minus \$47,600, or \$1,820,000 minus \$47,600, or \$1,772,400. That’s too much money to give up just to maintain a general pricing policy.

Chuck asks you: Was my analysis of the impact on operating income correct? If not, please show me the correct additional operating income if we had accepted this order.”

2. (7 points)After receiving your answer to question 1, Chuck said, “Forget that I had the Costco order. I had an even bigger order from Lands’ End. It was for 600,000 units and would have filled the plant completely. I told my mother I’d settle for no commission. There would have been no selling and administrative costs whatsoever because Lands’ End would pay for the shipping and would not get any advertising allowances.

Lands’ End offered \$15.00 per unit. Our fixed manufacturing costs would have been spread over 2.8 million instead of 2.2 million units. Wouldn’t it have been advantageous to accept the offer? Our old fixed manufacturing costs were \$5.00 per unit. The added volume would reduce that cost more than our loss on our variable costs per unit, as shown by the following calculations.

Old fixed manufacturing cost per unit, \$11,000,000 ÷ 2,200,000 =          \$5.00

New fixed manufacturing cost per unit, \$11,000,000 ÷ 2,800,000 =          3.93

"Savings per unit"                                                                                      \$ 1.07

Loss on variable manufacturing costs per unit, \$15.00 - \$16.00                 (1.00)

Net savings per unit in manufacturing costs                                               \$  .07

Therefore, accepting this large order would have increased our income by 600,000 unit x .07/unit = \$42,000.

Chuck asks you: Am I correct? If not, what would have been the impact on total operating income if we had accepted the order?”

As per the Figure 1, the contribution per hour for the two products need to be calculated. As per the contribution per hour for the two companies, since the contribution per hour for processing further into plug-in assemblies is less than the contribution per hour for subcomponent, subcomponents should be continued.

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