Knossos Limited is a manufacturer of standard and custom-designed bottling equipment. Early in December 2015, Larissa Company asked Knossos to quote a price for a custom-designed bottling machine to be delivered on April 1, 2016. Larissa intends to make a decision on the purchase of such a machine by January 1, so Knossos would have the entire first quarter of 2016 to build the equipment.
Knossos's standard pricing policy for custom-designed equipment is 50 percent markup on full cost. Larissa's specifications for the equipment have been reviewed by Knossos's engineering and cost accounting departments, and they made the following estimates for raw materials and direct labour:
Direct materials ..................................... $256,000
Direct labour (11,000 hours at $15) .............. 165,000
Manufacturing overhead is applied on the basis of direct labour hours. Knossos normally plans to run its plant with 15,000 direct labour hours per month and assigns overhead on the basis of 180,000 direct labour hours per year. The overhead application rate for 2016 of $9 per direct labour hour is based on the following budgeted manufacturing overhead costs for 2016:
Variable manufacturing overhead .................. $ 972,000
Fixed manufacturing overhead ..................... 648,000
Total..................................................... $1,620,000
The Knossos production schedule calls for 12,000 direct labour hours per month during the first quarter. If Knossos is awarded the contract for the Larissa equipment, production of one of its standard products will have to be reduced. This is necessary because production levels can only be increased to 15,000 direct labour hours each month on short notice. Furthermore, Knossos's employees are unwilling to work overtime.
Sales of the standard product equal to the reduced production will be lost, but there will be no permanent loss of future sales or customers. The standard product, whose production schedule will be reduced, has a unit sales price of $12,000 and the following cost structure:
Raw materials ................................ $2,500
Direct labour (250 hours at $15) ........... 3,750
Overhead (250 hours at $9) ................ 2,250
Total .......................................... $8,500
Larissa needs the custom-designed equipment to increase its bottle-making capacity so that it will not have to buy bottles from an outside supplier. Larissa Company requires 5,000,000 bottles annually. Its present equipment has a maximum capacity of 4,500,000 bottles with a directly traceable cash outlay of $0.15 per bottle. Thus, Larissa has had to purchase 500,000 bottles from a supplier at $0.40 each. The new equipment would allow Larissa to manufacture its entire annual demand for bottles at a raw material cost savings of $0.01 for each bottle manufactured. Knossos estimates that Larissa's annual bottle demand will continue to be 5,000,000 bottles over the next five years, the estimated economic life of the special-purpose equipment. Knossos further estimates that Larissa has an after-tax cost of capital of 15 percent and is subject to a 40 percent marginal income tax rate, the same rates as Knossos.
Required:
1. Knossos Limited plans to submit a bid to Larissa Company for the manufacture of the special-purpose bottling equipment.
a. Calculate the bid Knossos would submit if it follows its standard pricing policy for special-purpose equipment.
b. Calculate the minimum bid Knossos would be willing to submit on the Larissa equipment that would result in the same profits as planned for the first quarter.
2. What is the maximum price Larissa Company would likely pay for the machine? In your answer, assume that the equipment will be depreciated for tax purposes as a Class 8 asset (20 percent declining balance) and that it will have a salvage value of $100,000 at the end of its useful life.