Q25-11E - Horngren'S Financial And Managerial Accounting

Question

Newtown Sunglasses sell for about \(154 per pair. Suppose that the company incurs the following average costs per pair:

Direct materials                                                                  \)39

Direct labor                                                                          15

Variable manufacturing overhead                                6

Variable selling expenses                                               3

Fixed manufacturing overhead                                      20*

Total cost                                                                             \(83

* \)2,050,000 Total fixed manufacturing overhead / 102,500 Pairs of sunglasses

 

Newtown has enough idle capacity to accept a one-time-only special order from Water Shades for 17,000 pairs of sunglasses at \(80 per pair. Newtown will not incur any variable selling expenses for the order. 

Requirements 

1. How would accepting the order affect Newtown’s operating income? In addition to the special order’s effect on profits, what other (longer-term qualitative) factors should Newtown’s managers consider in deciding whether to accept the order?

2. Newtown’s marketing manager, Peter Kyler, argues against accepting the special order because the offer price of \)80 is less than Newtown’s $83 cost to make the sunglasses. Kyler asks you, as one of Newtown’s staff accountants, to explain whether his analysis is correct. What would you say?

Step-by-Step Solution

Answer

Answer

The expected increase in the operating income of the company would be $340,000.

Step-by-Step Solution Step 1: Meaning of Special Orders

Special orders refer to the orders received by the business entities from special customers (other than regular ones). Such orders are received for special prices, often less than the regular prices.

Step 2: Computation of operating income

Particulars	Amounts ($)
Expected increase in revenues (17000*80)	1,360,000
Less: Expected increase in variable manufacturing costs (17000*60) (Working notes)	(1,020,000)
Expected increase in operating income	$340,000

Working notes:

Computation of total variable cost:

Particulars	Amounts ($)
Direct materials	39
Direct labor	15
Variable manufacturing overhead	6
Total relevant variable cost	$60

Consideration of factors while accepting special orders:

A manager must consider the following factors:

• A manager must review the price demanded by a customer placing a special order with the company.
• It must be reviewed whether such a customer would deal with the company repeatedly or not.
• In addition, the manager must consider what impact the special order prices may have on the competitors. 

Step 3: Comment on the analysis

As per the given information and data, the analysis is inappropriate because $83 represents the mixed cost that the company incurs to produce a product. 

In addition, while making decisions on acceptance and rejection of the special orders, only a variable part of the manufacturing cost is considered because other costs remain the same and are not considered relevant for making decisions.