Problem 12 - Accounting

Question

Down Home Jeans Co. has an annual plant capacity of 65,000 units, and current production is 45,000 units. Monthly fixed costs are \(\$ 40,000\), and variable costs are \(\$ 22\) per unit. The present selling price is \(\$ 35\) per unit. On March 18,2010 , the company received an offer from Fields Company for 18,000 units of the product at \(\$ 29\) each. Fields Company will market the units in a foreign country under its own brand name. The additional business is not expected to affect the domestic selling price or quantity of sales of Down Home Jeans Co. a. Prepare a differential analysis report for the proposed sale to Fields Company. b. Briefly explain the reason why accepting this additional business will increase operating income. c. What is the minimum price per unit that would produce a contribution margin?

Step-by-Step Solution

Answer

a. Differential Operating Income = $126,000; b. Accepting additional business increases income as revenue > costs; c. Minimum price per unit > $22.

Step 1: Define the Differential Revenues and Costs

To prepare a differential analysis, identify the differential revenues and costs associated with accepting the Fields Company offer. The revenue from the Fields Company offer is calculated as follows: Revenue from Fields Company = 18,000 units × $29 per unit = $522,000. The variable cost associated with these 18,000 units is: Variable Cost = 18,000 units × $22 = $396,000.

Step 2: Compute the Differential Operating Income

The differential income can be calculated by subtracting the differential costs from the differential revenues: Differential Operating Income = Differential Revenues - Differential Costs. Differential Operating Income = $522,000 (from Step 1) - $396,000 (Variable Cost from Step 1). Differential Operating Income = $126,000.

Step 3: Analyze the Impact on Operating Income

The additional business will increase the operating income because the differential income is positive, meaning the revenue gain from Fields Company's offer exceeds the additional variable costs associated with the production of these units.

Step 4: Determine the Minimum Price per Unit for Contribution Margin

To find the minimum price per unit that would produce a positive contribution margin, we need the sale price per unit to be greater than the variable cost per unit. The variable cost per unit is $22. Therefore, the minimum price to produce a contribution margin is any price greater than $22.

Key Concepts

Cost Volume Profit Analysis

Cost Volume Profit (CVP) Analysis is a key financial concept used to determine how changes in costs and volume affect a company's operating income. This analysis aids management in understanding the relationship between cost structures, sales volume, and profitability. CVP Analysis helps businesses make informed decisions such as pricing strategies, cost control, and profit planning. For instance, by assessing both fixed and variable costs, companies can predict their break-even point – the point where total revenue equals total costs, resulting in no profit or loss.

• **Fixed Costs:** Costs that do not change with the volume of production, such as rent and salaries.
• **Variable Costs:** Costs that vary directly with the production volume, such as raw materials.
• **Revenue:** Income generated from regular business operations.
• **Profitability:** The degree to which a business yields financial gain.

By using CVP Analysis, Down Home Jeans Co. can assess the impact of accepting Fields Company's offer. This allows them to calculate how the offer, with its given sales volume and price, will influence overall profitability without influencing the existing sales channels or domestic pricing strategy.

Contribution Margin

The Contribution Margin is a crucial concept that indicates how much revenue from sales is contributing to covering a company's fixed costs and profit. It is calculated as the selling price per unit minus the variable cost per unit.
For Down Home Jeans Co., the normal selling price of a unit is $35 with a variable cost of $22, leading to a contribution margin of $13 per unit. However, Fields Company offers $29 per unit, creating a reduced but still positive contribution margin of $7 per unit. This means Down Home Jeans Co. still covers its variable costs and contributes to fixed costs with each unit sold to Fields Company.

• **Selling Price per Unit:** The price at which each unit is sold.
• **Variable Cost per Unit:** The cost of producing each unit, which varies with production.
• **Impact on Profit:** A positive contribution margin indicates that each sale contributes positively towards profit after covering variable costs.

In scenarios like this one, understanding the contribution margin helps the company decide on accepting offers below the standard price without incurring a loss on each additional unit sold.

Operating Income

Operating Income refers to the profit realized from a business's operations after deducting variable costs and fixed costs associated with production. It is a vital measure of the profitability of a company's core business activities. For Down Home Jeans Co., the decision to accept Fields Company's offer is informed by understanding how it affects their operating income. Accepting the offer adds $126,000 to the operating income, as calculated by subtracting the extra variable costs of $396,000 from the additional revenue of $522,000.

• **Revenue from Fields Company:** $522,000.
• **Associated Variable Costs:** $396,000.
• **Added Operating Income:** $126,000.
• **Core Activities:** Principal operations that contribute to the primary revenue-generating activities.

This addition to operating income demonstrates that the offer not only covers the relevant variable costs but also contributes significantly to the company's profitability. Therefore, even though the selling price for Fields Company is lower, it positively impacts the company's overall financial health by increasing operational profits.