This is a special order problem that also requires that you use the high low met

Question

This is a special order problem that also requires that you use the high low method to estimate some cost function parameters. For guidance, you may want to review the high-low method lectures in Module 1 and the high-low study problem solutions. As with almost all of the analyses that we have done, determining variable and fixed costs, and knowing what to do with them, is critical.
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Huang Automotive is presently operating at 75% of capacity. The company recently received an offer from a Korean truck manufacturer to purchase 20,000 units of a power steering system component for $200 per unit.  Peter Wu, vice-president of sales, notes that although there will be an additional $2.25 shipping cost for each component, he thinks that accepting the order will get the company's "foot in the door" of an expanding international market.

Huang's production and cost information for the last two years for the component are as follows:

T.J. Chan, vice-president of engineering, feels that any new market should first show its profitability and that the $200 per unit offer is not only below the regular $250 selling price, but it's below the unit cost of the component. She also points out that there will be additional setup costs of $280,000 and that Huang will have to lease some special equipment for $300,000.

Required
1. Using the high-low method to determine cost behavior, what would the expected profit be on the special order (use a negative sign for a loss)?

204,000 units     236,000 units     Direct material costs $17,850,000      $20,650,000      Direct labor costs 4,692,000      5,428,000      Overhead costs 20,506,000      22,154,000      Selling and administrative costs 10,036,000      10,324,000      Total costs $53,084,000      $58,556,000      Total costs per unit $260.22      $248.12     

Explanation / Answer

1. The semi-variable or semi-fixed costs are: Overhead costs and Selling and administrative costs

Variable overhead cost per unit

= (Cost at higher level of activity - Cost at lower level of activity)/ (higher level - lower level)

= ($22,154,000 - $20,506,000)/ (236,000 - 204,000)

= $1648000/ 32000

= $51.5

Fixed overhead costs

= Total overhead cost at higher level of activity - (Variable overhead cost per unit x No. of units)

= $22,154,000 - ($51.5 x 236,000)

= $10,000,000

2. Variable Selling and administrative cost per unit

= (Cost at higher level of activity - Cost at lower level of activity)/ (higher level - lower level)

= ($10,324,000 - $10,036,000 )/ (236,000 - 204,000)

= $288000/ 32000

= $9

Fixed Selling and administrative costs

= Total overhead cost at higher level of activity - (Variable overhead cost per unit x No. of units)

= $10,324,000 - ($9 x 236,000)

= $8,200,000

Now, only the variable expenses are relevant for special order consideration.

Total relevant cost to be incurred on special order = ($173.25 x 20,000) + 280,000 + 300,000

= $4,045,000

Expected profit (loss) on the special order = Sales - Cost

= ($20,000 x 200) - $4,045,000

= -$45000

Per unit Direct material costs $87.50 Direct labor costs 23.00 Variable Overhead costs 51.50 Variable Selling and administrative cost 9.00 Shipping cost 2.25 Total variable cost per unit $173.25

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