Pamela in Bamplona makes bull-repellent scent according to a traditional Spanish recipe, which normally sells at €9 (Euros) per unit. Normal production volume is 10,000 ounces per month. Average cost is €5 per ounce, of which €2 is direct material and €1 is variable conversion cost. This product is seasonal. After July, demand for this product drops to 6,000 ounces monthly. In November, Umberto offers to buy 1,500 ounces for €6,000. Now assume that the order is received in July, peak season. If Pamela accepts the order, she will turn away regular customers who order 500 ounces. Pamela should:

Question

Quizplus · Accepted Answer

First, let's calculate the cost per ounce:
Direct materials cost per ounce = €2
Variable conversion cost per ounce = €1
Total cost per ounce = direct materials cost per ounce + variable conversion cost per ounce = €3

Next, let's calculate the contribution margin per ounce:
Selling price per ounce = €9
Contribution margin per ounce = selling price per ounce - total cost per ounce = €9 - €3 = €6

This means that Pamela earns a profit of €6 per ounce sold.

In peak season (July), Pamela sells 10,000 ounces per month, earning a profit of €60,000 (€6 x 10,000). However, after July, demand drops to 6,000 ounces per month, earning a profit of €36,000.

Now let's consider the offer from Umberto. He wants to buy 1,500 ounces for €6,000, which means he is willing to pay €4 per ounce.

Pamela's total cost to produce 1,500 ounces is €7,500 (€5 per ounce x 1,500 ounces), which means she would lose €1,500 if she accepted Umberto's offer (€6,000 - €7,500).

Therefore, Pamela should reject the offer UNLESS Umberto raises the price to a level that covers her total cost per ounce plus a profit margin.

To calculate the minimum price that Umberto would need to offer, we can use the following formula:
Minimum Price = Total Cost per ounce + Profit Margin per ounce
Profit Margin per ounce = Contribution Margin per ounce - Variable Conversion Cost per ounce
Profit Margin per ounce = €6 - €1 = €5
Total Cost per ounce = Direct Materials Cost per ounce + Variable Conversion Cost per ounce
Total Cost per ounce = €2 + €1 = €3
Minimum Price = €3 + €5 = €8

This means that Umberto would need to offer at least €8 per ounce for Pamela to accept the order.

Since Umberto is offering only €4 per ounce, Pamela should reject the order (Choice C).

Pamela in Bamplona Makes Bull-Repellent Scent According to a Traditional