Textbook Problem

NoFat manufactures one product, olestra, and sells it to large potato chip manufacturers as the key ingredient in nonfat snack foods, including Ruffles, Lays, Doritos, and Tostitos brand products. For each of the past 3 years, sales of olestra have been far less than the expected annual volume of 125,000 pounds. Therefore, the company has ended each year with significant unused capacity. Due to a short shelf life, NoFat must sell every pound of olestra that it produces each year. As a result, NoFat’s controller, Allyson Ashley, has decided to seek out potential special sales offers from other companies. One company, Patterson Union (PU)—a toxic waste cleanup company—offered to buy 10,000 pounds of olestra from NoFat during December for a price of $2.20 per pound. PU discovered through its research that olestra has proven to be very effective in cleaning up toxic waste locations designated as Superfund Sites by the U.S. Environmental Protection Agency. Allyson was excited, noting that “This is another way to use our expensive olestra plant!”

The annual costs incurred by NoFat to produce and sell 100,000 pounds of olestra are as follows:

In addition, Allyson met with several of NoFat’s key production managers and discovered the following information:

• The special order could be produced without incurring any additional marketing or customer service costs.
• NoFat owns the aging plant facility that it uses to manufacture olestra.
• NoFat incurs costs to set up and clean its machines for each production run, or batch, of olestra that it produces. The total setup costs shown in the previous table represent the production of 20 batches during the year.
• NoFat leases its plant machinery. The lease agreement is negotiated and signed on the first day of each year. NoFat currently leases enough machinery to produce 125,000 pounds of olestra.
• PU requires that an independent quality team inspects any facility from which it makes purchases. The terms of the special sales offer would require NoFat to bear the $1,000 cost of the inspection team.

Assume for this question that NoFat rejected PU’s special sales offer because the $2.20 price suggested by PU was too low. In response to the rejection, PU asked NoFat to determine the price at which it would be willing to accept the special sales offer. For its regular sales, NoFat sets prices by marking up variable costs by 10%.

If Allyson decides to use NoFat’s 10% markup pricing method to set the price for PU’s special sales offer,

1. a. Calculate the price that NoFat would charge PU for each pound of olestra.
2. b. Calculate the relevant profit that NoFat would earn if it set the special sales price by using its markup pricing method. (Hint: Use the estimate of relevant costs that you calculated in response to Requirement 1b.)
3. c. Explain why NoFat should accept or reject the special sales offer if it uses its markup pricing method to set the special sales price.