Special export order below full cost
Northbridge Components manufactures a single product. Annual capacity is 60,000 units; current budgeted output and sales are 48,000 units at £42 per unit. Variable cost is £26 per unit (materials £12, direct labour £8, variable overhead £6), and annual fixed costs are £540,000. An overseas distributor has offered to buy 8,000 units at £33 each for a one-off export order. The order would require additional packaging costing £1.50 per unit and one-off export documentation of £7,000. Because of the delivery deadline, all 8,000 units would need overtime, adding a £2 per unit labour premium. Direct labour is paid on a piecework basis. The export order would not affect domestic sales, and no other use for the spare capacity is currently planned. The sales director is keen to accept to enter a new market. The finance director argues that £33 is below the full cost of £37.25 and will reduce profit. The production manager warns that accepting may set a low-price precedent.
1. Calculate the relevant cost and incremental profit of the export order. What is the minimum price per unit, ignoring qualitative factors?
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The key is to include only future, incremental cash costs. The full cost of £37.25 includes an apportionment of existing fixed costs: £540,000 / 48,000 = £11.25 per unit. Those fixed costs are incurred whether or not the order is accepted, and the order uses otherwise idle capacity, so they are not relevant.
Relevant cost per unit:
- Variable cost: £26.00
- Additional overtime premium: £2.00
- Additional packaging: £1.50
- Relevant cost before documentation: £29.50
One-off documentation: £7,000 / 8,000 units = £0.875 per unit. Total relevant cost per unit = £29.50 + £0.875 = £30.375, say £30.38.
Incremental profit:
- Revenue: 8,000 × £33 = £264,000
- Relevant costs: 8,000 × £29.50 + £7,000 = £236,000 + £7,000 = £243,000
- Incremental profit = £21,000
The minimum price is £30.375 per unit, which just covers the incremental costs. At £33 the order adds £21,000 to profit. However, the minimum is not necessarily the price to charge: the company should consider the precedent risk, the distributor's future expectations, and whether the export market will later support higher prices. The finance director's full-cost argument is not valid for a spare-capacity one-off order, but the sales director should not treat £33 as a long-term price.
2. The sales director also mentions that a regular domestic customer may place an order for 5,000 units at £42 in the same period, but this is not confirmed. Advise whether this should change the decision.
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If the domestic order is confirmed, capacity becomes binding. Spare capacity is 60,000 − 48,000 = 12,000 units. The export order needs 8,000 units, leaving only 4,000 units for the domestic order, which needs 5,000. The company would have to divert 1,000 units from export to domestic supply, or renegotiate the export quantity.
Compare contribution:
- Domestic sale contribution = £42 − £26 = £16 per unit. There is no overtime or extra packaging on domestic units.
- Export contribution after order-specific costs = £33 − £29.50 = £3.50 per unit before documentation. Documentation is fixed at £7,000 for the order.
If the company supplies 5,000 domestic units and reduces the export order to 7,000 units:
- Domestic contribution = 5,000 × £16 = £80,000
- Export contribution = 7,000 × £3.50 − £7,000 = £24,500 − £7,000 = £17,500
- Total = £97,500
That is much better than taking the 8,000-unit export order alone (£21,000). The domestic order should be prioritised if it is confirmed. If it is only probable, the company should quantify the probability and consider accepting the export order with a cancellation or rescheduling clause, or subcontracting, rather than turning away certain export contribution for an uncertain domestic order. The unconfirmed order is not an opportunity cost until it is reasonably certain.
3. Ignore the possible domestic order. The distributor now asks for 14,000 units at £33. Advise, showing calculations.
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Spare capacity is only 12,000 units, so a 14,000-unit order requires displacing 2,000 domestic units at £42. The displaced domestic units lose contribution of £42 − £26 = £16 per unit. There is no overtime or packaging on those domestic units.
Incremental revenue: 14,000 × £33 = £462,000. Relevant costs of export order:
- Variable, overtime and packaging: 14,000 × £29.50 = £413,000
- Documentation: £7,000
- Total = £420,000 Contribution before opportunity cost = £42,000.
Opportunity cost of displaced domestic sales: 2,000 × £16 = £32,000. Net incremental profit = £42,000 − £32,000 = £10,000.
The order is still profitable, but only by £10,000. The minimum price is (£420,000 + £32,000) / 14,000 = £32.29 per unit, so £33 is just above the minimum. Before accepting, the company should consider qualitative factors: the precedent of a £33 price, possible damage to domestic customer relationships, the risk that the distributor will demand larger volumes, and whether the 2,000 displaced domestic units can be supplied later. If the domestic customer is strategic, a £10,000 incremental profit may not compensate for the relationship risk. The decision is finely balanced, not automatic.