Special export order with idle capacity
Alexandria Juice Industries produces 80,000 cartons a year and has capacity for 100,000 cartons. Domestic sales are 80,000 cartons at EGP 80 each. Variable manufacturing cost is EGP 45 per carton and annual fixed costs are EGP 1,360,000. A Libyan distributor offers to buy 15,000 cartons at EGP 55 per carton. The order needs export packaging costing EGP 3 per carton and freight of EGP 2 per carton, and a one-off machine modification of EGP 60,000. No domestic sales would be affected. Alternatively, the distributor may order 25,000 cartons at the same price, which would require cutting domestic sales by 5,000 cartons because capacity is limited. The sales director wants to reject the 15,000-carton order because EGP 55 is below the EGP 62 full cost per carton. The production director wants to accept any order that covers variable cost.
1. Compute the full cost per carton, the break-even point, the margin of safety and the degree of operating leverage at the current domestic volume.
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Full cost per carton = variable cost 45 + fixed cost per carton. Fixed cost per carton at 80,000 units = 1,360,000 / 80,000 = 17. Full cost = 62. This explains the sales director figure but not the decision.
Contribution per carton = 80 - 45 = 35. Break-even = 1,360,000 / 35 = 38,857 cartons (rounded). Margin of safety = 80,000 - 38,857 = 41,143 cartons, or 51.4% of sales. Profit at current volume = 80,000 x 35 - 1,360,000 = 1,440,000. Degree of operating leverage = contribution / profit = 2,800,000 / 1,440,000 = 1.94. A 10% fall in sales would reduce profit by about 19.4% if costs behave as assumed.
2. Evaluate the 15,000-carton order using relevant costing and decide whether to accept it. Include qualitative factors.
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The relevant costs are the additional costs caused by the order. Incremental revenue = 15,000 x 55 = 825,000. Incremental variable manufacturing cost = 15,000 x 45 = 675,000. Export packaging = 15,000 x 3 = 45,000. Freight = 15,000 x 2 = 30,000. Machine modification = 60,000. Total incremental cost = 810,000. Incremental profit = 15,000.
The order should be accepted on financial grounds if the idle capacity has no better alternative use and the modification has no other value. The contribution is only EGP 1 per carton after the one-off cost, so the decision is marginal. The sales director is wrong to compare with full cost: the fixed costs are unchanged and are not relevant. The production director is also incomplete, because the order must cover packaging, freight and the modification, not just variable manufacturing cost. Qualitative factors include whether the export price will undermine domestic pricing, the credit and foreign-exchange risk, the possibility of repeat orders, the strategic value of entering the Libyan market, and whether the modification can be used for other products.
3. Analyse the 25,000-carton alternative and recommend a course of action.
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For 25,000 cartons, the export contribution before the one-off cost is 25,000 x (55 - 45 - 3 - 2) = 25,000 x 5 = 125,000. Deduct the modification of 60,000, leaving 65,000. However, producing 25,000 export cartons with capacity of 20,000 free means displacing 5,000 domestic cartons. Lost domestic contribution = 5,000 x 35 = 175,000. Net effect = 65,000 - 175,000 = -110,000.
The 25,000-carton order should be rejected unless the displaced domestic sales can be replaced at the same contribution or there are strategic benefits that justify the loss. The firm could counter-offer a smaller quantity, seek a higher export price, or consider whether the modification creates capacity for future profitable exports. The recommendation is to accept the 15,000-carton order only if no better use of capacity exists, and to reject the 25,000-carton order on the stated facts.