The San Carlos Company is an electronics business with eight product lines. Income data for one of the products (XT-107) for June 2007 are:
Revenues, 200,000 units at average price of
$100 each ................................................................ $20,000,000
Variable costs
Direct materials at $35 per unit ............................. $ 7,000,000
Direct manufacturing labor at $10 per unit ............... 2,000,000
Variable manufacturing overhead at $5 per unit ......... 1,000,000
Sales commissions at 15% of revenues .................... 3,000,000
Other variable costs at $5 per unit .......................... 1,000,000
Total variable costs .................................................... 14,000,000
Contribution margin ................................................... 6,000,000
Fixed costs .............................................................. 5,000,000
Operating income ...................................................... $ 1,000,000
Abrams, Inc., an instruments company, has a problem with its preferred supplier of XT-107 components. This supplier has had a three-week labor strike. Abrams approaches the San Carlos sales representative, Sarah Holtz, about providing 3,000 units of XT-107 at a price of $80 per unit. Holtz informs the XT-107 product manager, Jim McMahon, that she would accept a flat commission of $6,000 rather than the usual 15% of revenues if this special order were accepted. San Carlos has the capacity to produce 300,000 units of XT-107 each month, but demand has not exceeded 200,000 units in any month in the past year.
Required
1. If the 3,000-unit order from Abrams is accepted, how much will operating income increase or decrease? (Assume the same cost structure as in June 2007.)
2. McMahon ponders whether to accept the 3,000-unit special order. He is afraid of the precedent that might be set by cutting the price. He says, "The price is below our full cost of $95 per unit. I think we should quote a full price, or Abrams will expect favored treatment again and again if we continue to do business with them." Do you agree with McMahon? Explain.