The following data refer to the successful Munger division of Buffett Inc. Munger makes and sells high-end cordless drills. The drills sell for $ 80 each, and Munger expects sales of 300,000 units in 2014. Munger’s annual fixed costs are $ 4 million. The variable cost per drill is $ 48. Buffett evaluates Munger based on residual income. The total investment attributed to Munger is $ 16 million, and Buffett has a required rate of return on investment of 20%. Ignore taxes and depreciation expense. Answer each of the following parts independently, unless otherwise stated.

Required

1. What is the expected residual income in 2014?

2. Munger receives an external special order for 100,000 units at $ 60 each. If the order is accepted, Munger will have to incur incremental fixed costs of $ 850,000 and invest an additional $ 2 million in various assets. What is the effect on Munger’s residual income of accepting the order?

3. One of the components Munger manufactures for its drill has a variable cost of $ 4. An outside vendor has offered to supply the 300,000 units required at a cost of $ 5.25 per unit. If the component is purchased outside, fixed costs will decline by $ 200,000 and assets with a book value of $ 760,000 will be sold at book value. Will Munger decide to make or buy the component? Explain your answer.

4. One of Munger’s regular customers asks for a special drill made of tempered steel. The customer requires 15,000 drills. Munger estimates its variable cost for these special units at $ 54 apiece. Munger will also have to undertake new investment of $ 1,500,000 to produce the drills. What is the minimum selling price that will make the deal acceptable to Munger?

5. Assume the same facts as in requirement 4. Also suppose that the customer has offered $ 82 for each special drill. In addition, the customer has indicated that its purchases of the existing product will drop by 6,000 units.

a. What is the net change in Munger’s residual income from taking the offer, relative to its planned 2014 situation?

b. At what drop in unit sales of the regular drill would Munger be indifferent to the offer?