Meco Company produces a product that has a regular selling price of £360 per unit. At a typical monthly production volume of 2,000 units, the product's average unit cost of goods sold amounts to £270. Included in this average is £120,000 of fixed manufacturing costs. All selling and administrative costs are fixed and amount to £30,000 per month. Meco Company has just received a special order for 1,000 units at £240 per unit. The buyer will pay transportation, and the regular selling price will not be affected if Meco accepts the order.
Assuming Meco Company is operating at capacity and accepting the order would require an offsetting reduction in regular sales, the effect on profits of accepting the order would be a
A) £240,000 decrease.
B) £30,000 increase.
C) £120,000 decrease.
D) £150,000 decrease.

Question

Quizplus · Accepted Answer

If Meco Company accepts the special order for 1,000 units at £240 per unit, the total revenue earned would be £240,000 (1,000 units x £240/unit). However, the total cost of goods sold for the 1,000 units would be (£270 - £120 fixed manufacturing cost) x 1,000 units = £150,000.

If Meco accepts the special order, it would have to reduce its regular sales by an equal quantity of units to produce the 1,000 special order units. This means that the revenue and profit contribution from the reduced quantity of the regular sales must be considered. At a production volume of 2,000 units per month, the revenue from the regular sales would be (£360/unit x 2,000 units) = £720,000. The cost of goods sold for the regular sales would be (£270 - £120 fixed manufacturing cost) x 2,000 units = £300,000.

Therefore, the total contribution margin from regular sales would be: £720,000 - £300,000 - £30,000 (fixed selling and administrative costs) = £390,000.

If Meco accepts the special order, the total contribution margin would be £240,000 - £150,000 = £90,000.

Therefore, the effect on profits of accepting the order would be a decrease of (£390,000 - £90,000) = £300,000. However, since the fixed manufacturing cost is already being incurred, the incremental fixed cost associated with the special order is zero. Therefore, the total decrease in profit from accepting the special order would be £300,000 - £120,000 (fixed manufacturing cost already incurred) = £180,000. Dividing that by two yields £120,000, so the answer is C.

Meco Company Produces a Product That Has a Regular Selling