The Orange Mobile Manufacturing Company produces a single product which is sold to fabricators of electronic equipment. Since the company is relatively small, it does not utilize involved cost accounting techniques in determining inventory values. A simplified job order system is used with direct materials and direct labor being identified with specific lots of product. Factory overhead rates are not used; the company waits until the end of the accounting period for which statements are required and then assigns overhead to inventory and to cost of goods sold on a unit of production basis. During 19— the company produced its regular year's output by December 15 at which time it planned to shut down for the last two weeks of the year, reopening after the new year. As of December 1 5, the following income statement which included all 19— costs was prepared:
Orange Mobile Manufacturing Company
Income Statement
December 31, 19
Sales (20,000 units) $100,000
Cost of goods sold
Inventory, January 1, 19— — — 0
Production costs for an output of 22,000 units:
Direct materials $13,500
Direct labor 30,500
Factory overhead 35,200
Total $79,200
Inventory, December 31, 19— (2,000 units) 8,220 70,980
Gross profit on sales $ 29,020
Marketing and administrative expenses (all fixed) 10,000
Net income for the period (before income taxes) $ 19,020
On December 18, 19—, a department of the United States government placed an order with the company for 4,000 units of product. The company accepted the order which stipulated that delivery was to be made by December 31, 19— and that the company should be permitted to earn a gross profit on the order calculated as 20% of selling price. The company called back its productionpersonnel and completed 2,000 units by the end of the year which, with its inventory, made up the total of the government's order. During this period it expended additional costs as follows: direct materials, $1,300; direct labor, $2,800; and factory overhead, $800.
In accordance with the terms of the order, the government was billed at a price of $4.85 per unit. The government auditor who reviewed the company's invoice complained that at this price the company would earn a profit calculated on sales of 32.4% and that the unit sales price should have been $4.10 in order to comply with the terms of the order.
Required: (1) Calculations to show (a) how the company arrived at its price of $4.85 and (b) how the government reached a price of $4.10.
(2) A critical evaluation of the two pricing methods. Could acceptable accounting procedures be utilized to arrive at a third price for the order? Explain this third method and indicate which of the three methods is preferable in this instance.