Arequipa Enterprises (AE) began as a maker of industrial drafting equipment. After several successful years, the company has graduated into making two popular products: a plotter and a 3D printer. Both products have the same variable costs as shown below.

Variable costs per unit:

Direct materials $ 70

Direct labour $130

Variable manufacturing overhead $ 30

Sales Commission $20

Total $250

In order to maintain good customer service, AE keeps about 500 units of each product on hand as warehouse inventory.

The company has a long-term contract to rent manufacturing equipment and necessary space for $9,000,000 per year.General & administrative costs amount to $2,100,000 per year.

Costs and unit sales are expected to be consistent from last year to the current year.Based on last years' results, AE expects to sell 10,000 units of each product this year.The plotters are priced at $800 and the 3D printers at $1,000.

Rachel Merrett, president of the company, is considering how best to motivate her managers.She feels it is fair to provide bonuses once the company's operating income is 5% above the expected operating income.

Required:

1. Prepare a contribution format income statement for AE using variable costing.
2. Prepare an income statement for AE using absorption costing.
3. Based on Rachel's approach, what is the operating income level that AE must generate before managers are eligible for bonuses?
4. Rachel can specify the use of either the contribution format income statement or the absorption costing income statement in defining the bonus threshold.Which would you recommend she use?Explain why.

Part II

A few weeks later, Rachel is pondering how she should respond to a request for a bid that has just been brought in by her sales manager. The request comes from an overseas company operating outside of AE's usual market area and is for a one-time shipment of 5,000 customized 3D printers. The overseas company has offered to pay all shipping costs FOB plant.The customized printers would carry the same variable cost as AE's standard product but would require an estimated $100,000 in retooling costs to fulfill the custom specifications.

Rachel believes that currently the company has sufficient capacity to handle the additional 5,000 units of output without needing additional equipment or space. The production manager feels it would be possible to build the units, but the plant will be nearing or just over their capacity.

In considering what price to bid, Rachel wants to first determine the minimum price that she can accept on the order without lowering the company's operating income. The sales manager has suggested a figure of $720/unit) based on the following calculations:

Variable costs per unit $250

Fixed manufacturing cost per unit $450

Retooling costs per unit ($100,000/5,000 units) $20

Full manufacturing cost per unit $720

The production manager felt they could go as low as $630/unit, based on spreading the fixed manufacturing costs over 25,000 units rather than 20,000 units without the special order.

Required:

1. Based on the information provided, what is your advice to Rachel regarding the minimum price she can accept without reducing operating income?Explain your answer thoroughly.[Hint: Provide a revised income statement including the special order showing that operating income is unchanged.]
2. Assume the overseas customer is willing to buy at a price slightly above the minimum you recommended in part (e).Separate from the pricing decision, are there any other risks or concerns Rachel should consider before agreeing to accept the special order?List two risks/concerns and explain why each is a concern.