Question

PowerDrive, Inc. produces a hard disk drive that sells for $175 per unit. The cost of producing 25,000 drives in the prior year was:

Direct material		$625,000
Direct labor		375,000
Variable overhead		125,000
Fixed overhead		1,500,000
Total cost		$2,625,000

At the start of the current year, the company received an order for 3,400 drives from a computer company in China. Management of PowerDrive has mixed feelings about the order. On the one hand they welcome the order because they currently have excess capacity. Also, this is the company’s first international order. On the other hand, the company in China is willing to pay only $135 per unit.

What will be the effect on profit of accepting the order?

Answer 1

Since the company has excess capacity, only variable costs will be the extra costs for the order. Fixed costs should not be attributed to the order as they would remain the same irrespective of the fact whether we accept or reject the order.

Direct material cost per unit = $625000 / 25000 = $25

Direct labor cost per unit = $375000 / 25000 = $15

Variable overhead per unit = $125000 / 25000 = $5

Total variable cost per unit = $25 + $15 + $5 = $45

The computer company in China is willing to pay $135 per unit for the order. So, our margin on the order would be -

Margin = $135 - $45 = $90

Total increase in profit = $90 x 3400 = $306000

So, our profit would increase by $306,000.