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    Use of relevant cost for Decision making

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    Company A is operating a 70% capacity and is earning a satisfactory Return on Investment. Company A has been approached by Company B with an offer to buy 120,000 units. Company B needs the 120,000 valves over the next 4 months. Company B is prepared to pay $19 each for the units.

    Company A's product cost, based on current attainable standards, for the units are:

    Direct Materials - 5.00
    Direct Labor - 6.00
    Manufac. Sup. - 9.00
    total 20.00

    Manufacturing support costs are applied to production at the rate of $18 per standard direct labor hour and they pay for the shipping. This rate is made up of the following components:

    Flexible man. support - 6.00
    Capacity-related man. support - 12.00
    Cost driver rate - 18.00

    Additional cost incurred in connection with sales of the unit include sales commissions of 5% and freight expense of $1 a unit. However, the company does not pay sales commissions on special orders that come directly to management.

    In determining sales prices, Company A adds a 40% markup to product cost. This provides a $28 suggest selling price for the units. The marketing dept, however, has set the current selling price at $27 to maintain market share.

    Production management thinks it can handle the Company B order without disrupting its scheduled production. The order, would however, require additional capacity-related manufacturing support costs of $12,000 per month in the form of supervision and clerks.

    If management accepts the order 30,000 units will be manufactured and shipped to company B for the next 4 months. Shipments will be made in weekly consignments, with Company B paying for the shipping.

    Questions that I have are:

    1. What is the impact of accepting Company B's order on COmpany A's profits?

    2. What is the minimum unit price that Company A should accept for Company B's order without reducing its profits?

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    Solution Preview

    Ans 1
    There will be positive impact on net profit, as the contribution is positive
    Total Variable costs+ INCREMENTAL CAPACITY COST PER UNIT= 5+6+6+48000/30000=18.6

    Solution Summary

    This explains the use of costing techniques to make important decisions like pricing, acceptance of order