Question

The Morris Company manufactures wiring tools. The company is currently producing well below its full capacity. The Baker Company has approached Morris with an offer to buy 5,000 tools at $17.50 each. Morris sells its tools wholesale for $18.50 each; the average cost per unit is $18.30, of which $2.70 is fixed costs.

Required:

a. If Morris were to accept Baker's offer, what would be the increase in Miller's operating profits?
b. Assume that Morris is operating at full capacity. If Morris were to accept Baker's offer, what would be the change in Morris' operating profits?

Answer 1

In the case, Morris is working well below the capacity levels

Additional Revenue from the sales would be (5000*17.50) = $87,500

Less: Variable cost for the production (5000*(18.30-2.70)) = $78,000

Increase in Miller's operating profit would be = $9,500

Please note that fixed costs are ignored for the above calculation as they are irrelevant for the decision

In case working at full capacity

In case the working capacity is full capacity than the company will have to sacrifice the existing sales of the goods and contribution received from the same:

Additional Revenue from the sales would be (5000*17.50) = $87,500

Less: Variable cost for the production (5000*(18.30-2.70)) = $78,000

Less: Opportunity Cost - Contribution lost (5000*(18.50 - 15.6)) =$14,500

Addl benefit / loss from the Baker's order = -$5,000

It will lead to an extra loss of $5000 which is not recommended.