Question 6

Heath Production manufactures chairs. Several weeks ago, the company received an enquiry from Rose Limited. Rose wants to market a foldable chair similar to one of Heath’s, and has offered to purchase 11 000 units if the offer can be completed in three months. The cost data for Heath’s foldable chair is as follow:

Direct material                                         $16.40

Direct labour (0.125 @ $36 per hour) 4.50

Total manufacturing overhead                 20.00

Total                                                         $40.90

The normal selling price of Heath’s foldable chair is $53.00. However, Rose has offered Heath only $31.50 because of the large quantity it is willing to purchase. Rose requires a modification of the design that will allow a $4.20 reduction in direct material cost.

The production manager of Heath notes that the company will incur $7400 in additional setup costs and will have to purchase a $4800 special equipment to manufacturing the units for Rose. The equipment will be discarded once the special order is completed.

Total manufacturing overhead costs are applied to production at the rate of $40 per machine hour. The figure is based, in part, on budgeted annual fixed overhead of $1 500 000 and planned production activity of 60 000 machine hours (5000 hours per month).

Rose will allocate $3600 of existing fixed administrative costs to the order as “part of the cost of doing business”.

Required:

1. Which of the data above should be ignored in making the special order decision? For what reason?

2. Assume that Heath’s present sales will not be affected by the special order, should the order be accepted from the financial point of view? Show calculation.

3. Assume that Heath’s current production activity 80 per cent of planned machine hours, can the company accept the order and meet Rose’s deadline? Explain.