Case 1 Name:
Cost Formulas, Single and Multiple Cost Drivers
For the past 5 years, Garner Company has had a policy of producing to meet customer demand. As a result, finished goods inventory is minimal, and for the most part, units produced equal units sold.
Recently, Garner’s industry entered a recession, and the company is producing well below capacity (and expects to continue doing so for the coming year). The president is willing to accept orders that at least cover its variable costs so that the company can keep its employees and avoid layoffs. Also, any orders above variable costs will increase overall profitability of the company. Toward that end, the president of Garner Company implemented a policy that any special orders will be accepted if they cover the costs that the orders cause.
To help implement the policy, Garner’s controller developed the following cost formulas:
Direct Materials Usage = $94X, R2 = 0.90
Direct Labor Usage = $16X, R2 = 0.92
Overhead = $350,000 + $80X, R2 = 0.56
Selling Costs = $50,000 + $7X, R2 = 0.86
where X = Direct Labor Hours.
1. Compute the total unit variable cost. Suppose that Garner has an opportunity to accept an order for 20,000 units at a sales price of $212 per unit. Each unit uses 1 direct labor hour for production. Should Garner accept the order? (The order would not displace any of Garner’s regular orders.)
2. Explain the significance of the coefficient of determination measures for the cost formulas. Did these measures have a bearing on your answer in Requirement 1? Should they have a bearing? Why?
3. Suppose that a multiple regression equation is developed for overhead costs:
Y = $100,000 + $85X + $5,000S + $300E
where X = Direct Labor Hours, S = Number of Setups, and E = Engineering Hours.
The coefficient of determination for the equation is 0.89. Assume that the order of 20,000 units requires 12 setups and 600 engineering hours. Given this new information, should the company accept the special order referred to in Requirement 1? Is there any other information about cost behavior that you would like to have? Explain.