Opportunity costs

(H. Schaefer, adapted) The Wild Orchid Corporation is working at full production capacity producing 13,000 units of a unique product, Everlast. Manufacturing cost per unit for Everlast is:

Manufacturing overhead cost per unit is based on variable cost per unit of $8 and fixed costs of $78,000 (at full capacity of 13,000 units). Marketing cost per unit, all variable, is $4, and the selling price is $52.
A customer, the Apex Company, has asked Wild Orchid to produce 3,500 units of Stronglast, a modification of Everlast. Stronglast would require the same manufacturing processes as Everlast. Apex has offered to pay Wild Orchid $40 for a unit of Stronglast and share half of the marketing cost per unit.

Required:
1. What is the opportunity cost to Wild Orchid of producing the 3,500 units of Stronglast? (Assume that no overtime is worked.)
2. The Chesapeake Corporation has offered to produce 3,500 units of Everlast for Wild Orchid so that Wild Orchid may accept the Apex offer. That is, if Wild Orchid accepts the Chesapeake offer, Wild Orchid would manufacture 9,500 units of Everlast and 3,500 units of Stronglast and purchase 3,500 units of Everlast from Chesapeake. Chesapeake would charge Wild Orchid $36 per unit to manufacture Everlast. On the basis of financial considerations alone, should Wild Orchid accept the Chesapeake offer? Show your calculations.
3. Suppose Wild Orchid had been working at less than full capacity, producing 9,500 units of Everlast, at the time the Apex offer was made. Calculate the minimum price Wild Orchid should accept for Stronglast under these conditions. (Ignore the previous $40 selling price.)

1. The opportunity cost to Wild Orchid of producing the 3,500 units of Stronglast is the contribution margin lost on the 3,500 units of Everlast that would have to be forgone, as computed below:
Selling price
Variable costs per unit:
Direct materials
Direct manufacturing labor
Variable manufacturing overhead
Variable marketing costs
Contribution margin per unit
Contribution margin for 3,500 units ($28 ´ 3,500 units) $ 52

$10
2
8
4 24
$ 28
$98,000

The opportunity cost is $98,000. Opportunity cost is the maximum contribution to operating income that is forgone (rejected) by not using a lim¬ited resource in its next-best alternative use.

2. Contribution margin from manufacturing 3,500 units of Stronglast and purchasing 3,500 units of Everlast from Chesapeake is $105,000, as follows:
Manufacture
Stronglast Purchase
Everlast
Total
Selling price
Variable costs per unit:
Purchase costs
Direct materials
Direct manufacturing labor
Variable manufacturing costs
Variable marketing overhead
Variable costs per unit
Contribution margin per unit
Contribution margin from selling 3,500 units of Stronglast and 3,500 units of Everlast
($18 ´ 3,500 units; $12 ´ 3,500 units) $ 40

–
10
2
8
2
22
$ 18

$63,000 $ 52

36

4
40
$ 12

$42,000

$105,000
As calculated in requirement 1, Wild Orchid's contribution margin from continuing to manufacture 3,500 units of Everlast is $98,000. Accepting the Apex Company and Chesapeake offer will benefit Wild Orchid by $7,000 ($105,000 – $98,000). Hence, Wild Orchid should accept the Apex Company and Chesapeake Corporation's offers.

3. The minimum price would be any price greater than $22, the sum of the incremental costs of manufacturing and marketing Stronglast as computed in requirement 2. This follows because, if Wild Orchid has surplus capacity, the opportunity cost = $0. For the short-run decision of whether to accept Apex's offer, fixed costs of Wild Orchid are irrelevant. Only the incremental costs need to be covered for it to be worthwhile for Wild Orchid to accept the Apex offer.