25-2TI - Horngren'S Financial And Managerial Accounting

Question

Thomas Company makes a product that regularly sells for \(12.50 per unit. The product has variable manufacturing costs of \)8.50 per unit and fixed manufacturing costs of \(2.00 per unit (based on \)200,000 total fixed costs at current production of 100,000 units). Therefore, the total production cost is \(10.50 per unit. Thomas Company receives an offer from Wesley Company to purchase 5,000 units for \)9.00 each. Selling and administrative costs and future sales will not be affected by the sale, and Thomas does not expect any additional fixed costs. 

1. If Thomas Company has excess capacity, should it accept the offer from Wesley? Show your calculations. 

2. Does your answer change if Thomas Company is operating at capacity? Why or why not?

Step-by-Step Solution

Answer

1. The offer should be accepted if the Thomas company has excess capacity.
2. The offer should be rejected if the Thomas company is operating at capacity.

 

Meaning of Fixed Cost

In accounting, fixed cost refers to the cost that is independent and is not affected by the level of production or quantity of goods produced by a business. Such a cost remains the same for zero production and other levels.

Decision on the order acceptance

Particulars	Amounts ($)
Expected increase in revenue (5,000*$9)	45,000
Less: Expected increase in variable manufacturing cost (5,000*$8.50)	(42,500)
Expected increase in operating income	$2,500

The company operating at its capacity

Particulars	Amounts ($)
Revenue at capacity sales price (5,000*$9)	45,000
Less: Revenue at regular sales price (5,000*$12.50)	(62,500)
Expected decrease in sales revenue	($17,500)

In the second scenario, Thomas Company should reject the offer because it will result in decreased sales revenue.