Question

The Rewehon department at Greenwich plc manufactures high quality toy cars for customers in the London area. Selected data from the budget for the 12 months ending 31^st December is available:
Budget 2000

	£
Sales (90,000 units)	2,700,000
Cost of goods sold (see notes 1 and 2)	1,800,000
Gross profit	900,000
Selling general & administrative overheads (see note 3)	650,000
Profit before tax	250,000

Note 1. Cost of goods sold includes fixed costs of £400,000
Note 2. If production is increased from 90,000 units to 100,000 units per annum it is estimated that fixed costs will increase by £20,000
Note 3. Sales commission on the existing orders is 7.5% of sales and is included in the total cost of £650,000. All other costs are assumed to be fixed.

Capacity
The current capacity at the factory is 100,000 units per year. In the budget for the year the company expect to sell 90,000 units.
New order
After agreeing the budget a company in South Africa contacted Greenwich to discuss two orders. This is an unusual situation, as the Rewehon department has never exported before.
The first order is for 10,000 units but if the selling price is reduced they will place a larger order. Rewehon have to accept only 1 order. Details of the orders are as follows:

Order 1*
Quantity	10,000 units
Selling price	£22 per unit

*The sales commission for this order will increase to 10%. Additional variable shipping costs will be 5% of sales value and additional insurance to export the toy cars will be £3,000. (Also refer to note 2 above)

Order 2**
Quantity	20,000 units
Selling price	£21 per unit

**The sales commission for this order will be 10%. Additional variable shipping costs will be 5% of sales value and additional insurance costs will be £8,000. (Also refer to note 2 above) Calculate the relevant fixed costs for order 2.

Multiple Choice

• £28,000.

• £18,000.

• £1,000.

• £20,000.

Answer 1

As per current budget,

Sales = 90000 units

Fixed Cost = £400,000

If production is increased from 90,000 units to 100,000 units, then incremental fixed cost would be £20,000.

Thus, if the company accepts order number 2 of 20,000 units, then production would have to be increased to 100,000 units. Therefore, the fixed cost for order number 2 would be the incremental fixed cost to be incurred on capacity expansion to 100,000 units i.e. £20,000

Important note - In case the company accepts order number 2, then the budgeted sales would be 110,000 units (90,000 + 20,000). However, the company only has production capacity of 100,000 units. Thus, in order to fulfill order number 2, the company would have to forgo 10,000 units of the initial sales budget of 90,000 units. Hence, the profit forgone on this 10,000 units in order to fulfill order number 2 is an opportunity cost.