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incremental net income

Aurora Industries manufactures a hand-held electric hair dryer. Sales have steadily increased during the recent past and, as a result of a just-completed expansion program, Aurora has annual capacity now of 250,000 units. Production and sales during the coming year are forecast at 150,000 units. Standard production costs have been estimated as:

Materials $3.00
Direct Labor 2.00
Variable Indirect Labor 0.50
Fixed overhead 1.00
Allocated cost per unit $6.50
In addition to production costs, Aurora incurs fixed selling expenses of $0.50 per unit and variable warranty repair expenses of $0.75 per unit. It currently receives $8.25 per unit from its customers-primarily retail department stores-and it expects this price to continue to hold during the coming year.
After making the above projections, Aurora received an inquiry from a discount department store for a large number of units. The inquiry contained two purchase offers:
Offer 1-The department store would purchase 100,000 units at $8 per unit. These units would bear the Aurora brand and the Aurora warranty would cover them.
Offer 2-The department store would purchase 150,000 units at $7 per unit. These units would be sold under the buyer's private label and Aurora would not provide warranty service.

Three questions(include calculations supporting answers):

(A) Evaluate the incremental net income from each offer.

(B) What factors other than incremental net income should Aurora take into consideration in deciding which offer to accept?

(C) Which offer, if either, should Aurora accept and why?

Solution Preview

(A) Evaluate the incremental net income from each offer.

As per the figures given above, in case of offer 1, the total cost per unit will be:

Allocated cost: 6.50
Fixed selling expenses: .50
Warrantly repair expenses: .75

Total: 7.75 per unit

For 100, 000 units at $8/unit, incremental net income will be 100,000 * .25 (8-7.75) or 25,000 dollars.

In the case of offer 2, the total cost per unit will be the above mentioned cost minus the warranty expense of .75, ie, 7.75-.75 or $7.

Therefore, the company will be selling the product at break even pricing, based on above estimates at $7 per unit.

From these calculations, ...

Solution Summary

Evaluate the incremental net income from each offer.