Absorption costing, idle capacity and a special order
Rodopi Furniture EOOD produces 20,000 office chairs per year at practical capacity of 25,000 units. Normal activity for overhead absorption is set at 80% of practical capacity, i.e. 20,000 units. Budgeted fixed production overhead is BGN 3,600,000 per year; variable production cost is BGN 95 per chair. The selling price is BGN 180. A foreign retailer offers a one-off order of 4,000 chairs at BGN 118 each, to be delivered from existing capacity. The order requires a special removable logo costing BGN 4 per chair and a one-off tooling cost of BGN 30,000. The sales director supports acceptance because BGN 118 exceeds the BGN 95 variable cost. The production director objects that the full absorption cost is BGN 95 + (3,600,000 / 20,000) = BGN 275, so the order loses money. Current sales are 20,000 units and the order would not affect them.
1. Evaluate the special order using relevant costing and reconcile the two directors' figures.
Read the worked answer
The production director's BGN 275 is a full absorption cost per unit at normal activity, not a relevant cost. It includes BGN 180 of fixed overhead per unit (3,600,000 / 20,000). Those fixed costs are incurred whether or not the order is accepted, because the order fits within existing idle capacity (20,000 of 25,000 units used). They are therefore not incremental and must be excluded.
Relevant cost per chair: variable production 95 + special logo 4 = BGN 99. Plus the one-off tooling of 30,000 spread over 4,000 units = BGN 7.50 per unit. Relevant cost per unit = BGN 106.50. Contribution = 118 - 106.50 = BGN 11.50 per unit; total contribution = 4,000 x 11.50 = BGN 46,000, or computed directly: incremental revenue 472,000 less incremental costs (4,000 x 99 = 396,000 + 30,000 tooling) = 46,000.
The order is financially attractive provided no better use of the capacity exists and the order does not cannibalise existing sales. Both conditions are stated as met. The sales director's reasoning is right in direction but incomplete: he ignored the logo and tooling.
Reconciliation: the BGN 275 includes BGN 180 of fixed overhead that is a sunk/committed cost in this decision. The difference between 275 and 106.50 is the non-relevant fixed element plus the fact that absorption at 20,000 units allocates all fixed overhead to normal volume.
2. The foreign retailer now asks for 8,000 chairs. Analyse the decision and state the minimum acceptable price.
Read the worked answer
At 8,000 units, total demand would be 28,000, exceeding the 25,000 practical capacity. Only 5,000 units of idle capacity exist. Producing 8,000 requires displacing 3,000 units of normal sales at BGN 180.
Opportunity cost of displaced sales = 3,000 x contribution per normal unit. Normal contribution = 180 - 95 = BGN 85, so opportunity cost = BGN 255,000.
Incremental analysis for 8,000 units:
- Revenue: 8,000 x P
- Variable cost: 8,000 x 99 = 792,000
- Tooling: 30,000
- Lost contribution: 255,000
Break-even price: 8,000P = 792,000 + 30,000 + 255,000 = 1,077,000, so P = BGN 134.63 minimum.
At the offered BGN 118, the order destroys value: contribution = 8,000 x 19 = 152,000, less tooling 30,000, less lost contribution 255,000 = negative BGN 133,000. Reject at 118, or negotiate above 134.63.
Note also that fixed overhead absorption would change if volume rises: at 28,000 units the fixed overhead per unit falls to BGN 128.57, which further demonstrates that absorption cost is volume-dependent and unsuitable for this decision. Any overtime premium or capacity expansion cost would raise the floor further.