Question

This is a special order problem that also requires that you use the high low method to estimate some cost function parameters, so you may want to review the high-low method lectures in Module 1. As with almost all of the analyses that we have done, determining variable and fixed costs, and knowing what to do with them, is critical.
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Huang Automotive is presently operating at 75% of capacity. The company recently received an offer from a Korean truck manufacturer to purchase 23,500 units of a power steering system component for $195 per unit.  Peter Wu, vice-president of sales, notes that although there will be an additional $2.50 shipping cost for each component, he thinks that accepting the order will get the company's "foot in the door" of an expanding international market.

Huang's production and cost information for the last two years for the component are as follows:

	202,000 units	232,000 units
Direct material costs	$16,867,000	$19,372,000
Direct labor costs	5,454,000	6,264,000
Overhead costs	23,701,000	25,216,000
Selling and administrative costs	9,022,000	9,352,000
Total costs	$55,044,000	$60,204,000
Total costs per unit	$272.50	$259.50

T.J. Chan, vice-president of engineering, feels that any new market should first show its profitability and that the $195 per unit offer is not only below the regular $250 selling price, but it's below the unit cost of the component. She also points out that there will be additional setup costs of $270,000 and that Huang will have to lease some special equipment for $240,000.

Required
1. Using the high-low method to determine cost behavior, what would the expected profit be on the special order (use a negative sign for a loss)?

Answer 1

Solution:

Direct material cost per unit = $16,867,000/202000 = $83.50 per unit

Direct labor cost per unit = $5,454,000 / 202000 = $27 per unit

Variable overhead cost per unit (high low method) = ($25,216,000 - $23,701,000) / (232000 - 202000) = $50.50 per unit

Variable selling cost per unit (high low method) = ($9,352,000 - $9,022,000) / (232000 - 202000) = $11 per unit

Variable cost per unit for special order = regular variable cost per unit + Additional shipping cost

= ($83.50 + $27 + $50.50 + $11) + $2.50 = $174.50 per unit

Expected profit (loss) on special order = Contribution margin from special order - Additional setup cost - Additional cost of leasing equipment

= ($195 - $174.50) * 23500 - $270,000 - $240,000 = ($28,250)