Policarpio, Jerome S.

20058568 MSEM

GSECOMAN 08/04/2018

Case 1: Cost Analysis of Patio Furniture

The Leisure Products (LP) Company manufactures lawn and patio furniture. Most of its output is
sold to do-it-yourself warehouse stores (e.g., Lowe’s Home Improvement) and to retail hardware
and department store chains (e.g., Ace Hardware and JCPenney), who then distribute the
products under their respective brand names. LP is not involved in direct retail sales. Last year
the firm had sales of $35 million.

One of LP’s divisions manufactures folding (aluminum and vinyl) chairs. Sales of the chairs are
highly seasonal, with 80 percent of the sales volume concentrated in the January–June period.
Production is normally concentrated in the September–May period. Approximately 75 percent of
the hourly workforce (unskilled and semiskilled workers) is laid off (or takes paid vacation time)
during the June–August period of reduced output. The remainder of the workforce, consisting of
salaried plant management (line managers and supervisors), maintenance, and clerical staff,
are retained during this slow period. Maintenance personnel, for example, perform major
overhauls of the machinery during the slow summer period.

LP planned to produce and sell 500,000 of these chairs during the coming year at a projected
selling price of $7.15 per chair. The cost per unit was estimated as follows:

A 10 percent markup ($0.65) was added to the cost per unit in arriving at the firm’s selling price
of $7.15 (plus shipping).

In May, LP received an inquiry from Southeast Department Stores concerning the possible
purchase of folding chairs for delivery in August. Southeast indicated that they would place an
order for 30,000 chairs if the price did not exceed $5.50 each (plus shipping). The chairs could
be produced during the slow period using the firm’s existing equipment and workforce. No
overtime wages would have to be paid to the workforce in fulfilling the order. Adequate materials
were on hand (or could be purchased at prevailing market prices) to complete the order.

LP management was considering whether to accept the order. The firm’s chief accountant felt
that the firm should not accept the order because the price per chair was less than the total cost
and contributed nothing to the firm’s profits. The firm’s chief economist argued that the firm
should accept the order if the incremental revenue would exceed the incremental cost.

The following cost accounting definitions may be helpful in making this decision:

• Direct labor: Labor costs incurred in converting the raw material into the finished product.

• Material: Raw materials that enter into and become part of the final product.

• Plant overhead: All costs other than direct labor and materials that are associated with the
product, including wages and salaries paid to employees who do not work directly on the
product but whose services are related to the production process (line managers, maintenance,
and janitorial personnel), heat, light, power, supplies, depreciation, taxes, and insurance on the
assets employed in the production process.

• Selling and distribution costs: Costs incurred in making sales (e.g., billing and salespeople’s
compensation), storing the product, and shipping the product to the customer. (In this case the
customer pays all shipping costs.)

• Administrative costs: Items not listed in the preceding categories, including general and
executive office costs, research, development, engineering costs, and miscellaneous items.
Questions

1. Calculate the incremental variable, or marginal, cost per chair to LP of accepting the order
from Southeast.

Variable cost includes direct labor and material cost, and hence the incremental / marginal cost
per unit will stay $4.55 (2.25+2.3).

∆𝑇𝐶
𝑀𝐶 = ∆𝑄
; ∆𝑇𝐶 = ∆𝑉𝐶 + ∆𝐹𝐶

VC1 = (2.25 + 2.3)*(500,000) = $ 2,275,000

VC2 = (2.25 + 2.3)*(530,000) = $ 2,411,500

VC = $136,500

FC1 = FC2, since plant maintenance cost, admin cost is fixed with or without additional orders.

FC = 0

TC = VC + FC

TC = 136,500 + 0

TC = $ 136,500

∆𝑇𝐶 136,000
𝑀𝐶 = = ; Where Q = 530,000 – 500,000 = 30,000
∆𝑄 30,000

MC = 4.55

Material Labor Q (# of D Q (# of D VC (in D TC (in

Legend (Per Unit) (Per unit) units) units)
VC (in $)
$)
TC (in $)
$)
MC (in $)

*1 2.25 2.3
500,000 2,275,000 2,275,000
*2 2.25 2.3 136500 4.55
530,000 30,000 2,411,500 136,500 2,411,500
Legend: * 1 – current order, * 2 – with additional 30,000 units order from Southeast Department Stores

2. What assumptions did you make in calculating the incremental variable cost in Question 1?
What additional information would be helpful in making these calculations?
Since the chairs could be produced during the slow period using the firm’s existing equipment
and workforce, the acceptance of offer won’t lead to any additional Fixed Cost like “Plant
Overhead” and “Administrative & Selling Overhead”. Fixed cost is general and to needed to be
paid by LP regardless of accepting or rejecting the order. Labor Cost is assumed to be fixed
expense and it has to be paid off whether there is production or not. So, labor cost will not
impact the decision of accepting or rejecting the order.
Units Units
Cost Cost/unit 500000 30000

Direct labor 2.25 1,125,000 67,500

Materials 2.3 1,150,000 69,000

Plant Overhead 1.15 575,000 -

Administrative & Selling
Overhead 0.8 400,000 -

Total Cost 3,250,000 136,500

General Sale at 7.15/unit 3,575,000

Order Sale at 5.5/unit 165,000

Profits 325,000 28,500

3. Based on your answers to Questions 1 and 2, should LP accept the Southeast order?

The order must be accepted. There is a profit of $ 28,500 from accepting the order. And also
that the $5.5 offer price is greater than the relevant cost of $4.55.

4. What additional considerations might lead LP to reject the order?

 Change in production efficiency due to the 75% reduction of manpower

(unskilled and semiskilled workers) which reduces LP’s capacity.
 Unavailability of materials and manpower after the production of the initial
500,000 units.
 Increase in the prices of raw materials and other related direct materials that
will make the cost higher than the offer price.