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The following financial data apply to the DVD production plant of the Dill Company for October 2011 : Variable manufacturing overhead varies with the number of DVD packs produced. Fixed manufacturing overhead of \(\$ 1\) per pack is based on budgeted fixed manufacturing overhead of \(\$ 150,000\) per month and budgeted production of 150,000 packs per month. The Dill Company sells each pack for \(\$ 5\) Marketing costs have two components: \(\bullet\)Variable marketing costs (sales commissions) of \(5 \%\) of revenues \(\bullet\)Fixed monthly costs of \(\$ 65,000\) During 0ctober \(2011,\) Lyn Randell, a Dill Company salesperson, asked the president for permission to sell 1,000 packs at \(\$ 4.00\) per pack to a customer not in Dill's normal marketing channels. The president refused this special order because the selling price was below the total budgeted manufacturing cost. 1\. What would have been the effect on monthly operating income of accepting the special order? 2\. Comment on the president's "below manufacturing costs" reasoning for rejecting the special order. 3\. What other factors should the president consider before accepting or rejecting the special order?

Step by step solution

01

Calculate Revenue from Special Order

For the 1,000 packs at \\( 4.00 each, the total revenue would be: \( 1,000 \times 4 = \\) 4,000 \). This is the direct income from the special order.

02

Compute Variable Manufacturing Cost

Since the variable manufacturing cost varies with production, if these costs are not explicitly given, they should be zero for the special order as fixed costs cover this component in existing production, for simplicity of this calculation.

03

Calculate Variable Marketing Costs

Variable marketing costs are 5% of revenues. Therefore, for this special order, it would be: \( 0.05 \times 4,000 = \$ 200 \).

04

Calculate Contribution Margin

Subtract the variable marketing costs from the revenue to determine the additional contribution margin from the special order:\( 4,000 - 200 = \$ 3,800 \). This is the impact on the operating income if the order is accepted.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Variable Manufacturing Overhead

Variable manufacturing overhead refers to costs that change in proportion to production output. In simpler terms, these are the extra expenses a company incurs as it produces more units. Examples include direct material costs, electricity for machinery, and worker wages tied to production levels. In our DVD plant scenario, it's important to note that variable costs are significant because they directly affect the cost structure as production numbers shift.

As seen in the exercise, focusing solely on fixed overhead can lead to misconceptions. The president might have misunderstood the incremental costs tied to the additional order acceptance. This misunderstanding can stem from wrongly attributing all costs as _fixed_ rather than recognizing that variable manufacturing overhead costs often change when output levels increase. So, awareness of these costs helps in making more informed decisions about special orders. Understanding how these costs directly link to production can provide valuable insights into short-term pricing and product decisions.

Fixed Manufacturing Overhead

Fixed manufacturing overhead costs remain constant regardless of the volume of production. These can include expenses like rent, salaries of permanent staff, and depreciation of equipment. In the Dill Company exercise, a fixed overhead of $1 per pack is based on a predetermined budget, assuming stable production levels.

These fixed costs can sometimes mask the contribution of additional production to operating income. In scenarios where a decision-maker considers only the average cost per unit, it can lead to rejecting profitable opportunities. The president's reasoning pointed to a misunderstanding that the selling price was below the full budgeted manufacturing cost, including both fixed and variable components. However, since fixed costs are already covered by existing production, any price above the variable cost contributes positively to covering fixed costs and thus increases overall profitability.

Contribution Margin

The contribution margin is a crucial metric that represents how much sales contribute to covering fixed costs after variable costs have been deducted. Calculated as sales revenue minus variable costs, it aims to showcase the financial benefit of specific sales activities. For Dill Company, calculating the contribution margin of the special order means looking at the revenue minus the variable marketing costs.

Understanding the contribution margin is critical, especially when evaluating special pricing decisions like the discount request presented by Lyn Randell. Although the selling price was below the average total cost, it provided a positive contribution margin of $3,800, indicating an increase in overall operating income if the special order were accepted.

Evaluating opportunities through the lens of contribution margin ensures that decision-making isn't clouded by averaged overhead figures, highlighting that additional sales opportunities — even at reduced prices — can still enhance profitability.