Question

Harrison Ford Company has been approached by a new customer with an offer to purchase 10,000 units of its model IJ5 at a price of $4.00 each. The new customer is geographically separated from the company's other customers, and existing sales would not be affected. Harrison normally produces 75,000 units of IJ5 per year but only plans to produce and sell 60,000 in the coming year. The normal sales price is $12 per unit. Unit cost information for the normal level of activity is as follows:

Direct Materials $1.75
Direct Labor 2.50
Variable Overhead 1.50
Fixed Overhead 3.25
Total $9.00

Required:
a. What are the relevant costs and benefits of the two alternatives (accept or reject the special order)?
b. By how much will operating income increase or decrease if the order is accepted?

Answer 1

a. The relevant costs and benefits of the two alternatives are as follows:

Relevant costs = $57,500

Relevant benefits = $40,000

b. Operating income will decrease if the order is accepted by $17,500.

Step-by-step explanation:

a. What are the relevant costs and benefits of the two alternatives (accept or reject the special order)?

Note that accepting the special order will increase the planned production from 60,000 to 70,00. Since this still lower than normal 75,000 units of production, this implies that Fixed Overhead will not be incurred when the order is accepted. Therefore, the Fixed Overhead is not relevant in this situation.

Therefore, the relevant costs and benefits of the two alternatives are as follows:

Relevant costs = Units of special order * (Direct Materials + Direct Labor + Variable Overhead) = 10,000 * ($1.75 + $2.50 + $1.50) = $57,500

Relevant benefits = Revenue from the special order = Units of special order * Unit price of special order = $10,000 * $4 = $40,000

b. By how much will operating income increase or decrease if the order is accepted?

Amount of decrease in operating income = Relevant costs - Relevant benefits = $57,500 - $40,000 = $17,500

Since the relevant costs will greater than the relevant benefits, it can be observed from the calculation above that operating income will decrease if the order is accepted by $17,500.