Kavya Exports: A ₹610 Order, Overtime and the Automation Case
Kavya Exports runs a single garment factory in Tiruppur. Monthly fixed costs are ₹60 lakh (lease, salaried staff, interest, insurance). The cost accountant reports variable cost of ₹640 per unit at the current 40,000 units a month - but ₹80 of that is the firm's flat ₹32 lakh monthly design-studio retainer, spread across units. Practical capacity is 46,000 units a month; beyond that, overtime costs an extra half of the ₹240 wage component. The current order book is 40,000 units at ₹700.
A European buyer offers a one-off 12,000-unit order at ₹610, to be produced and shipped within the same month. Separately, over three years the firm's long-run average cost fell from ₹790 at 20,000 units to ₹705 at 60,000 units. An automated line is quoted at ₹35 lakh extra fixed cost per month with a ₹90 per unit cut in avoidable variable cost. The promoters want a decision on the export order this week and a view on automation before the next board meeting.
1. Should Kavya accept the 12,000-unit order at ₹610? Show the incremental analysis and the counter-offer you would put to the buyer.
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Correct the cost base first. The ₹32 lakh design retainer is fixed - it is incurred whether or not the order is taken - so the accountant's ₹640 overstates avoidable cost by ₹80. True avoidable variable cost = ₹560/unit.
Split the order by capacity. Spare capacity is 46,000 − 40,000 = 6,000 units. The remaining 6,000 units require overtime at 0.5 × ₹240 = ₹120/unit.
| Slab | Units | Avoidable cost | Price | Contribution/unit | Total |
|---|---|---|---|---|---|
| Spare capacity | 6,000 | ₹560 | ₹610 | +₹50 | +₹3.00 lakh |
| Overtime | 6,000 | ₹680 | ₹610 | −₹70 | −₹4.20 lakh |
| Total | 12,000 | −₹1.20 lakh |
Decision. Reject the full order as offered - it destroys ₹1.2 lakh of value, and the ₹60 lakh of fixed cost is irrelevant to that comparison. The classic absorption-costing error would be to compare ₹610 with ₹640 and reject outright; that is right by accident, for the wrong reason, and it would wrongly reject a smaller order.
Counter-offer. Take 6,000 units at ₹610 (+₹3 lakh contribution) and quote the residual 6,000 at ₹685–₹700 to cover overtime plus a margin. Alternatively ask the buyer to allow delivery across five weeks, which removes the overtime entirely and makes the full 12,000 units worth ₹6 lakh.
Check before signing. Confirm there are no incremental fixed costs (buyer audits, special packing, freight), and confirm no existing customer has a most-favoured-customer clause that the ₹610 price would trigger.
2. The finance director says: 'We are already making a loss, so any order that covers variable cost reduces the loss.' Where is this argument right and where does it fail here?
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Where it is right. In the short run fixed costs are sunk and unavoidable. Any output priced above avoidable marginal cost adds contribution and shrinks the loss; refusing such output because it does not cover fully absorbed cost is the error that closes factories unnecessarily. The shut-down test is price below minimum average avoidable cost - here ₹700 exceeds ₹560, so the plant should keep running.
Where it fails in this case.
- The variable cost used is wrong. ₹640 includes a ₹80 fixed allocation. The decision must use ₹560 on spare capacity and ₹680 with overtime - and at ₹680, ₹610 does not cover avoidable cost.
- Capacity is not free. The last 6,000 units consume overtime that has an alternative use: any full-price order that arrives later in the month. The relevant comparison is the contribution forgone, not zero.
- 'One-off' rarely stays one-off. A ₹610 transaction price becomes the reference point for the next negotiation with the same buyer and, if it leaks, with existing customers. That is a real cost not in the arithmetic.
- Cash timing. If payment terms stretch to 90 days, the working-capital cost of the order must be added to avoidable cost.
Synthesis. The director's principle is correct at the level of marginal reasoning but is being applied with an average, absorption-based cost number and no capacity constraint. Corrected, the rule becomes: accept output where price ≥ avoidable marginal cost including the opportunity cost of the capacity used.
3. Should Kavya buy the automated line? Use the scale data and set out the conditions under which the answer flips.
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Break-even volume. Extra fixed cost ₹35 lakh ÷ ₹90 saved per unit = 38,889 units a month. Current volume is 40,000, so the line pays - but only by ₹90 × 40,000 − ₹35 lakh = ₹1 lakh a month. That is a 2.5% margin of safety on a decision that raises fixed costs by more than half.
Sensitivity.
- Volume falls 10% to 36,000: saving ₹32.4 lakh < ₹35 lakh → the line loses ₹2.6 lakh a month. Export demand is cyclical and the firm's order book is seasonal, so a 10% swing is entirely plausible.
- Volume rises to 52,000 (existing book plus the buyer's order as a contract): saving ₹46.8 lakh → +₹11.8 lakh a month, a clear yes.
What the long-run cost data say. LRAC falling from ₹790 at 20,000 units to ₹705 at 60,000 shows economies of scale and a minimum efficient scale somewhere at or above 60,000 units. Automation lowers the variable cost but raises the volume needed to be cost-competitive: it shifts the firm further along a high-fixed-cost strategy. That is rational only if volumes are contractually secured.
Conditions that flip the decision.
- Yes if the 12,000-unit order converts into a 12–24 month contract, or if the firm can lease the line with a cancellation option.
- No if volumes stay at 40,000 with normal seasonal variance, or if financing the ₹35 lakh adds interest cost not included in the ₹90 saving.
- Either way, model the higher operating leverage explicitly: at 40,000 units the firm's loss is already large, and automation makes the loss steeper below break-even even as it improves profit above it.