Question

The Melville Corporation produces a single product called a Pong. Melville has the capacity to produce 60,000 Pongs each year. If Melville produces at capacity, the per unit costs to produce and sell one Pong are as follows:

Direct materials	$	15
Direct labor	$	12
Variable manufacturing overhead	$	8
Fixed manufacturing overhead	$	9
Variable selling expense	$	8
Fixed selling expense	$	3

The regular selling price for one Pong is $80. A special order has been received by Melville from Mowen Corporation to purchase 6,000 Pongs next year. If this special order is accepted, the variable selling expense will be reduced by 75%. However, Melville will have to purchase a specialized machine to engrave the Mowen name on each Pong in the special order. This machine will cost $9,000 and it will have no use after the special order is filled. The total fixed manufacturing overhead and selling expenses would be unaffected by this special order. Assume that direct labor is a variable cost.

Assume Melville anticipates selling only 50,000 units of Pong to regular customers next year. At what selling price for the 6,000 special order units would Melville be financially indifferent between accepting or rejecting the special order from Mowen?

Multiple Choice

• $51.50 per unit

• $38.50 per unit

• $49.00 per unit

• $37.00 per unit

Answer 1

This question is a special order decision making question.

Therefore there are certain things that you need to keep in mind:

1. Direct or avoidable costs of production: the minimum priced charge should always consider all costs that will be incurred if this order is accepted Example: Variable costs that fluctuate based on the production capacity. Anything that will be incurred even if this order is not accepted should not be considered. This rules also applies for a Make or Buy Decision question.

2. Level of operating Capacity: The minimum priced charge would also be affected by the capacity at which the company is operating. So if the company is operating at full capacity (i.e all equipment, labor and facilities are utilized for the orders in hand) then there is no need to accept a special order provided that they are able to recover the amount of contribution (Selling price- Variable costs) that they lost from the existing order in order to fulfill the special order.

Rule 1: Operating at less than full capacity: If this corporation is operating at less than full capacity then they have sufficient capacity to produce this special order. Here we just need to calculate the Direct costs (Variable) as explained above to be calculated in determining the minimum price in order to accept this order.

Rule 2: Operating at full Capacity: In this case it must include the cost that need to be forgone of the existing order in order to accept this special order. Therefore we need to calculate the contribution of the existing order to calculate the opportunity cost and that would be the cost that needs to be priced to take up the special order.

Now once you understood these above concepts we can now move on to the problem in hand:

Here we can see that Melville Corporation has a maximum capacity of 60,000 units but it assumed that for the next year the capacity will be at 50,000. This shows that Melville will be operating at less than full capacity when this special order needs to be fulfilled. Therefore in this Special order decision we will be calculating the Avoidable costs directly related to the special order as per the Point 2 Rule 1 explained above.

Direct Avoidable costs here in the questions are as follows:

Direct Material $15

Direct Labor: $12

Variable Manufacturing Overhead $ 8

Variable Selling Expense $ 2

One time cost of New Machine $ 1.5

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Total Avoidable cost: $ 38.50

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Now let me explain why i have considered these amounts:

• Direct Material,Direct Labor, Variable manufacturing Overhead, Variable selling expense is a variable cost as it increases or decreases on the number of units produced.
• As explained in the problem the Fixed overhead will be incurred irrespective of the number of units produced and hence these costs are unavoidable.
• I have considered the Variable Selling Expense as $2 as stated in the problem if the special order is considered the Variable Selling expense will reduce by 75% i.e $8- ($8*75%)=$2
• If the special order is accepted then as stated in the problem we will have to purchase a new machine at $9000 to produce the 6,000 special units hence the per unit cost will be $9000/6000 = $1.5 as this is incurred only for the special order and will not be used for any regular order. This is a one time use machine only for this special order.

Conclusion: Therefore after the considerations explained above, Melville Corporation can accept the special order from Moven Corporation only if the Selling price is $38.50 and above.