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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?

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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.

$2.19
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Q3. The Tanner Corporation is a highly successful marketer of raw leather to producers of various lines of leather products. The company is considering expanding by selling to makers or custom leather automobile seats. Tanner's marketing VP Estimates that this market can add $700,000 in new sales. However, since many of the firms in the custom auto seat business are small independent companies, the financial V.P. estimates that 12 percent of the accounts will be uncollectible and he is arguing against the firm's expansion into this new market segment. The cost of producing and marketing the leather in this market is estimated to be 70 percent of sales. Tanner's tax rate is 35 percent. All sales are made on credit.

a) What will Tanner's incremental net income (after taxes) be it if enters the new market?

b) If Tanner has a receivables turnover ratio of 4 times and an inventory turnover ratio of 10 times, how much will the firm have to invest in new receivables and new inventory to support the sales in the new market segment?

c) If Tanner requires a minimum return on investment in assets of 18 percent, should the firm enter the new market...or is the financial VP correct in her assessment of the situation? Do some quick calculations and explain very briefly, why the firm should or should not enter the custom auto seat market.

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