The £38 Order at Merrow Components
Merrow Components makes two products on the same machines. Budgeted annual fixed production overhead is £180,000, recovered on machine hours. Budgeted output is 6,000 units of A (2 machine hours each) and 3,600 units of B (5 machine hours each), which exactly fills the factory's normal 30,000 hours. Direct costs per unit are: A - materials £18, labour £14; B - materials £35, labour £22. Current selling prices, set last year, are A £52 and B £95. A distributor now offers to buy 1,500 units of A at £38 each. The sales director wants to reject it immediately: 'Our full cost is £44, so at £38 we lose £6 a unit on every one.' The factory can actually run 32,000 hours a year, and the remaining 2,000 hours are currently unused.
1. Calculate the overhead absorption rate and the full unit cost of A and B, and assess whether the £44 full cost is a sound basis for the sales director's decision.
Read the worked answer
Absorption rate = £180,000 ÷ 30,000 machine hours = £6.00 per machine hour.
| A | B | |
|---|---|---|
| Direct materials | 18.00 | 35.00 |
| Direct labour | 14.00 | 22.00 |
| Overhead (A: 2 hrs × £6; B: 5 hrs × £6) | 12.00 | 30.00 |
| Full cost | 44.00 | 87.00 |
The £44 is arithmetically correct but it is not a relevant cost for this decision:
- The £12 of overhead is an apportionment of a fixed cost that will be incurred whether or not the order is taken. Rejecting the order saves only the £32 variable cost, not £44.
- Machine-hour absorption simply spreads a fixed pool over budgeted hours; it says what a unit 'should' cost at budgeted volume, not what producing 1,500 more units costs.
- The rate also depends on volume. If output fell, the same £180,000 would be spread over fewer hours and the 'cost' of A would rise - without any change in the cost of making it.
So 'we lose £6 a unit' is an absorption-costing artefact. The correct test is the contribution the order generates against the opportunity cost of the capacity it consumes.
2. Evaluate the offer on a relevant-cost basis and state the minimum price at which the order would be acceptable.
Read the worked answer
Step 1 - unit contributions.
- A: £52 − £32 = £20 contribution over 2 hours = £10.00 per machine hour
- B: £95 − £57 = £38 contribution over 5 hours = £7.60 per machine hour
Step 2 - capacity. 1,500 units of A need 3,000 hours. Only 2,000 hours are spare (1,000 units), so 1,000 hours must be taken from B: 1,000 ÷ 5 = 200 units of B displaced, contribution forgone 200 × £38 = £7,600.
Step 3 - outcome at £38.
- Contribution from the order: 1,500 × £6 = £9,000
- Less contribution forgone: (7,600)
- Net gain: £1,400
So the order is not loss-making - but it is barely worth having.
Step 4 - minimum prices.
- For 1,000 units (fits spare capacity): minimum price = variable cost = £32.00, giving £6,000 contribution.
- For 1,500 units: required contribution = £7,600 ÷ 1,500 = £5.07 per unit, so minimum price = £37.07.
Judgement. Compare the two deals, not just the order with nothing: supplying 1,000 units earns £6,000, while supplying 1,500 earns only £1,400. Each unit beyond 1,000 contributes £6 but displaces 0.4 units of B (£15.20 of contribution) - a marginal loss of £9.20. The best response is a counter-offer of 1,000 units at £38; only if the distributor insists on take-it-or-leave-it at 1,500 should Merrow accept, and then purely because £1,400 beats nil.
3. What qualitative and longer-term factors should the board weigh before accepting or refusing the order?
Read the worked answer
- Price leakage. A is sold to existing customers at £52. A distributor buying at £38 may resell into the same market, forcing a general price reduction that costs far more than the £1,400 gained.
- Precedent. Accepting a below-full-cost price once makes it hard to refuse similar requests from core customers.
- Damage to B customers. The 1,500-unit version requires cutting supply to B. If B customers are lost or contractual penalties apply, the real cost is far above the £7,600 of contribution.
- The 'spare' 2,000 hours may not be free - it may be needed for maintenance, training or expected growth in demand; and if the order runs into overtime, the £32 variable cost understates the cost.
- Strategic use of capacity. The 2,000 hours could instead support promotional volume of A at full price, earning £10 per hour rather than £3 per hour on the incremental 500 units.
- Customer relationship value. A distributor may become a large long-term buyer - but only if the relationship is structured with volume/price steps so that the low price is confined to the marginal units.