Question

1. Spurrier Company has two production divisions, Solar and Home Audio, which operate within a single building in Denver. Solar has been reporting annual losses for some time and senior management is considering its elimination. The Solar division makes one product, a set of solar powered headphones. The relevant range for this product is between 10,000 and 15,000 units per year.

The following information is provided about the Solar division’s performance during the last fiscal year:

Solar Division Income Statement for year ended 12/31/2018                      $

Revenue (10,000 units x $50 per unit)                                                           500,000

Unit level variable costs Direct materials (10,000 units x $10 per unit)        (100,000)

Variable manufacturing overhead (10,000 x $20 per unit)                            (200,000)

Sales commissions (10,000 x $2 per unit)                                                      (20,000)

Contribution margin                                                                                      180,000

Fixed Expenses Building utilities                                                                     (150,000)

Building rent                                                                                                   (30,000)

Salary of production supervisor for the solar product                                   (60,000)

Fixed advertising costs for solar powered headphones                                 (10,000)

Net loss for the year                                                                                      (70,000)

1. Building utilities are Solar’s share of building utilities. This cost is unavoidable if the division is closed.
2. Building rent is Solar’s share of building rental. Rent costs are fixed under a long-term lease agreement and must be paid regardless whether the building is actually being used to its full capacity.         

Required:

a) Should the Solar Division be closed? Support your answer by providing a calculation that shows the net impact of the revenues lost and costs avoided because of the division’s elimination. Clearly state all assumptions.  

b) An outside supplier has offered to produce the 10,000 sets of headphones that Spurrier requires for $34 per unit. If this offer is accepted, production activities within the Solar Division would end, although the following costs are unavoidable:

- Fixed yearly advertising costs for the Solar powered headphones

- Variable sales commission of $2 per unit.

- Building rent

- Building utilities

Should Spurrier buy the headphones externally? Explain your answer by providing calculations that compare the costs avoided through the closure of the Solar Division with the cost of buying headphones externally.    

c) Assume that the Solar Division is kept open and the outsourcing option is rejected. The company can supply a customer with an additional order for 5,000 sets of headphones at $35 per unit. Should Spurrier accept this additional order? Justify your answer by providing a calculation that shows the net impact of the additional revenue and incremental costs from only supplying this extra order.   

Answer 1

Advantage of closing division = Fixed costs Avoided – Contribution Margin lost

= Salary of Supervisor + Advertising cost – 180,000

= 70,000-180,000

= $(110,000)

i.e. loss

Hence, the division should NOT be closed

b)Relevant cost of making internally i.e. avoidable cost

= Direct material + overhead + Salary of supervisor

= 10+20+60,000/10,000

= $36 per unit

Should buy as external cost is lower

Note: Selling expenses will be incurred under both the cases and hence, are not relevant

c)Income from Order = Incremental Revenues – Incremental costs

= (35-10-20-2)*5000

= $15,000

Should accept

Note: since there is spare capacity, no increase in fixed costs will be required due to special order