What Is The Financial Advantage Or Disadvantage Of Accepting

What is the financial advantage (disadvantage) of accepting the special order?

Delta Company produces a single product with a normal capacity of 121,200 units per year. The cost per unit at a production level of 85,200 units includes direct materials ($1.70), direct labor ($2.00), variable manufacturing overhead ($1.00), fixed manufacturing overhead ($4.15), variable selling and administrative expenses ($1.20), and fixed selling and administrative expenses ($1.00). The regular selling price of the product is $19.00 per unit. An order has been received for 3,000 units at a special price of $16.00 per unit, which will not affect regular sales or fixed costs. The key question is whether accepting this order provides a financial advantage or disadvantage.

Analysis of the Special Order

To determine the profitability of accepting the special order, it is crucial to analyze the relevant costs associated with producing the additional units. Since the order does not impact regular sales or fixed costs, only variable costs are relevant for this decision. These include direct materials, direct labor, variable manufacturing overhead, and variable selling and administrative expenses.

The per-unit variable costs are as follows:

  • Direct materials: $1.70
  • Direct labor: $2.00
  • Variable manufacturing overhead: $1.00
  • Variable selling and administrative expenses: $1.20

Sum of variable costs per unit: $1.70 + $2.00 + $1.00 + $1.20 = $5.10

Revenue from the special order per unit: $16.00

Variable cost per unit: $5.10

Contribution margin per unit: $16.00 - $5.10 = $10.90

Total contribution from the order: $10.90 x 3,000 units = $32,700

Since fixed manufacturing overhead and fixed selling and administrative expenses do not change with this order, their costs are not relevant. Therefore, accepting the order results in a positive contribution of $32,700, indicating a financial advantage.

Conclusion: The acceptance of the special order yields a financial advantage of $32,700.

Relevant Unit Cost for Selling Inferior Inventory

Separately, the company has 1,000 units of older, inferior products in inventory that need to be sold at reduced prices. The key consideration for pricing these units is the relevant unit cost, which determines the minimum acceptable selling price. This cost includes the variable costs incurred in producing these units, as fixed costs are sunk and do not influence short-term pricing decisions.

Since the units are produced last year, and are considered inferior, the relevant unit cost should exclude fixed manufacturing overhead allocated in the past, especially if these costs are sunk or no longer relevant to current decisions. In this context, the relevant unit cost is the variable cost per unit:

  • Direct materials: $1.70
  • Direct labor: $2.00
  • Variable manufacturing overhead: $1.00
  • Variable selling and administrative expenses: $1.20

Total relevant unit cost: $5.10

This cost provides the basis for establishing the minimum price at which the old inventory can be sold without incurring a loss. If the sale price is below $5.10, the company would be worse off financially; selling at or above this price covers the variable costs and contributes toward fixed costs and profit.

Conclusion: The relevant unit cost for establishing a minimum selling price for the inferior units is $5.10.

Analysis of Dorsey Company's Joint Products and Further Processing Decisions

Dorsey Company manufactures three joint products (A, B, and C) from a common input, with total joint costs of $365,000 per quarter. The products’ sales value at split-off and their further processing costs are provided: Product A sells at $23.00/lb, with a quarterly output of 13,600 pounds, and incurs additional processing costs of $78,540, resulting in a final price of $28.40 per pound after further processing. Product B sells at $17.00/lb, with 21,200 pounds, with additional processing costs of $113,230, and a final price of $23.40 per pound. Product C sells at $29.00/gallon, with 4,800 gallons, with additional costs of $50,560, and a final price of $37.40 per gallon.

The primary focus is to evaluate whether each product should be processed further or sold at split-off, based on the incremental analysis of additional processing costs versus additional revenue.

Calculating the Financial Advantage of Further Processing

  • Product A:
  • Additional costs: $78,540
  • Incremental revenue: (Final price - Split-off price) multiplied by units
  • Final price after processing: $28.40
  • Original selling price at split-off: $23.00
  • Incremental revenue per pound: $28.40 - $23.00 = $5.40
  • Total incremental revenue: $5.40 x 13,600 = $73,440
  • Since the incremental revenue of $73,440 exceeds the additional processing costs of $78,540, processing further results in a net disadvantage of $5,100.
  • Product B:
  • Additional costs: $113,230
  • Final price after processing: $23.40
  • Split-off price: $17.00
  • Incremental revenue per pound: $23.40 - $17.00 = $6.40
  • Total incremental revenue: $6.40 x 21,200 = $135,680
  • Additional revenue exceeds processing costs, implying a favorable net advantage of $22,450 for further processing.
  • Product C:
  • Additional costs: $50,560
  • Final price: $37.40
  • Split-off price: $29.00
  • Incremental revenue per gallon: $37.40 - $29.00 = $8.40
  • Total incremental revenue: $8.40 x 4,800 = $40,320
  • Incremental revenue exceeds additional costs, resulting in a net advantage of $-9,760, indicating processing is disadvantageous for Product C.

Recommendations Based on Incremental Analysis

Products B and A generate favorable net advantages if processed further, suggesting these products should be processed beyond the split-off point. Conversely, Product C incurs a net disadvantage, so it should be sold at split-off to maximize profitability.

Conclusion

Deciding whether to process further depends on incremental analysis. The analysis indicates that Products A and B benefit from additional processing, while Product C does not. This aligns with efficient resource utilization and profit maximization objectives. Properly assessing costs and revenues at each decision point allows management to make informed choices that enhance overall financial performance.

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