Question

Fairmount Travel Gear produces backpacks and sells them to vendors who sell them under their own label. The cost of one of its backpacks follows.

Materials	$	18.20
Labor		12.20
Variable overhead		5.20
Fixed overhead ($2,802,400 per year; 452,000 units per year)		6.20
Total	$	41.80

Riverside Discount Mart, a chain of low-price stores, has asked Fairmount to supply it with 21,000 backpacks for a special promotion Riverside is planning. Riverside has offered to pay Fairmount a unit price of $44 per pack. The regular selling price is $62. The special order would require some modification to the basic model. These modifications would add $4.20 per unit in material cost, $1.70 per unit in labor cost, and $0.70 in variable overhead cost. Although Fairmount has the capacity to produce the 21,000 units without affecting its regular production of 452,000 units, a one-time rental of special testing equipment to meet Riverside’s requirements would be needed. The equipment rental would be $55,800 and would allow Fairmount to test up to 52,000 units.

Required:

a. Prepare a schedule to show the impact of filling the Riverside order on Fairmont’s profits for the year.

b. Do you agree with the decision to accept the special order?

c. Considering only profit, determine the minimum quantity of backpacks in the special order that would make it profitable.

Answer 1

a. Schedule showing the impact of filling the Riverside order on Fairmont's profits for the year Operating results of Fairmount Travel Gear
At normal stage of production:
		(All values in $)
Particulars	Regular Production (4,52,000 Units)
Unit Price	Amount
Sales	62.00	28,024,000.00
Less: Variable Cost
Material Cost	18.20	8,226,400.00
Labour Cost	12.20	5,514,400.00
Variable Overhead	5.20	2,350,400.00
Contribution		11,932,800.00
Fixed Overhead		2,802,400.00
Profit		9,130,400.00
When the special order is considered in addition to normal production:
					(All values in $)
Particulars	Regular Production (4,52,000 Units)	Special Order Production (21,000 Units)	Net Effect [(a) + (b)]
Unit Price	Amount (a)	Unit Price	Amount (b)
Sales	62.00	28,024,000.00	44.00	924,000.00	28,948,000.00
Less: Variable Cost
Material Cost	18.20	8,226,400.00	22.40	470,400.00	8,696,800.00
Labour Cost	12.20	5,514,400.00	13.90	291,900.00	5,806,300.00
Variable Overhead	5.20	2,350,400.00	5.90	123,900.00	2,474,300.00
Contribution		11,932,800.00		37,800.00	11,970,600.00
Fixed Overhead		2,802,400.00		55,800.00	2,858,200.00
Profit/(Loss)		9,130,400.00		(18,000.00)	9,112,400.00

As per the above tables, it can be seen that the acceptance of Riverside's special order production will make the Fairmount Travel Gear's profit down by $ 18,000.00.

b. The decision to accept the special order is not favourable since it results in profit decline by $ 18,000.00.

c. The minimum quantity to be ordered by Riverside so as to make the order profitable for Fairmount Travel Gear:

First, we need to find out the present profit volume ratio on account special production of 21,000 units.

Profit Volume Ratio = Contribution / Sales

Therefore, Profit Volume Ratio = $ 37,800.00 / $ 9,24,000.00 = 4.09%

In order to make the special order production at a "no profit no loss point", we have to compute the break even sales. That is, the sales at which there will be no profit and no loss.

Thus break even sales on production of 21,000 units = Fixed Cost / Profit Volume Ratio

That is, $ 55,800.00 / 4.09% = $ 13,64,303.00

The selling price for special order units is $ 44.00 per unit. Therefore, the minimum units of backpacks to be included in the special order is ($ 13,64,303.00 / $ 44.00) = 31,007 units. When the special production is at 31,007 units, there will be "no profit no loss" stage for the production.

Hence, it can be said that, an order of minimum 31,007 units or above that will make the special order production profitable since the selling price is $ 44.00 and the total variable cost is $ 42.20. Also, the one-time rental of special equipment testing is $ 55,800.00 which allow for a test upto 52,000 units whereas the minimum units to be included in the special order is considered to be 31,007 units.