The Leisure Products (LP) Company manufactures lawn and patio furniture. Most of its output is sold to do- it- yourself warehouse stores (e. g. , Lowes Home Improvement) and to retail hardware and department store chains (e. g. , True Value 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 LPs 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 (un-skilled 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: Direct Labor $2. 25 Materials 2. 30 Plant Overhead* 1. 15 Administrative & selling expense* 0. 80 TOTAL $6. 50 * These costs are allocated to each unit of output based on the projected annual production of 500,000 chairs. A 10 percent markup ($ 0. 65) was added to the cost per unit in arriving at the firms 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 firms 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. Answer the following questions: 1. Calculate the incremental, or marginal, cost per chair to Leisure Products of accepting the order from Southeast? 2. What assumptions did you make in calculating the incremental cost in Question 1?
What additional information would be helpful in making these calculations? 3. Based on your answers to Questions 1 and 2, should Leisure Products accept the Southeast order? 4. What additional considerations might lead Leisure Products to reject the order? Solution 1. Marginal cost per chair to Leisure Products = $4. 55 (Direct labor + Direct Materials) 2. While calculating incremental cost in Q1, I made following assumptions: a. The cost of labor would remain same i. e. there will no overtime wages. b.
LP will be able to produce 30,000 chairs to fulfill the order from Southeast with its existing capacity. c. The cost of materials will remain same. There is additional information given in the case to support my calculation in Q1. Since the customer is bearing the shipping cost, the selling and distribution costs is ignored for decision making. Administrative cost and plant overhead are indirect costs and are allocated to estimate size of production. Since these costs do not change irrespective of production, such cost is not considered for calculation of marginal cost per chair.
3. Since selling price per chair exceeds the marginal cost per chair, LP should accept the order. This order will have positive impact on the profitability of LP. 4. Following considerations may lead Leisure Products to reject the order: a. The existing capacity is not adequate and new capacity would be required to complete the order. b. Overtime and more labor resources affecting the labor cost would be required to complete the order. c. LP will have to bear the selling and distribution costs. d. Changes in market affecting material or labor cost can affect the decision.