Priced to Fill a Bottleneck: The Modified-Unit Order at Arvon Precision
Arvon Precision Components runs a single CNC machining shop with 42,000 machine hours available next year. Budgeted demand is 6,000 units of Product A (price ₹1,850, variable cost ₹1,120, 4.0 machine hours) and 2,400 units of Product B (price ₹2,400, variable cost ₹1,600, 6.0 machine hours). A trading house offers ₹1,500 for 3,000 units of a modified A that would consume 4.0 hours each and carry a variable cost of ₹1,180, including ₹260 of direct labour. The order must be delivered in the third quarter, and the works manager confirms no additional machine capacity can be installed before year-end, although overtime on direct labour is available at a 40% premium. The sales director wants to accept: "We have 3,600 idle hours, so the order uses capacity we are already paying for and adds ₹9.6 lakh of contribution." The commercial head warns that the trading house already supplies two of Arvon's OEM customers and could resell the modified unit under its own brand. The board wants a priced recommendation, not a view.
1. Evaluate the sales director's ₹9.6 lakh contribution claim. Show contribution per machine hour for each product, the hours the order consumes, and the minimum acceptable price under both displacement assumptions.
Read the worked answer
Rank by the scarce resource, not by margin per unit.
| A | B | |
|---|---|---|
| Contribution/unit | ₹730 | ₹800 |
| Machine hours | 4.0 | 6.0 |
| Contribution/hour | ₹182.50 | ₹133.33 |
Budgeted load = (6,000 × 4) + (2,400 × 6) = 24,000 + 14,400 = 38,400 hours against 42,000 available, so genuine idle capacity is only 3,600 hours.
The order needs 3,000 × 4 = 12,000 hours, i.e. 8,400 hours must be taken from existing products. The sales director's error is treating all 12,000 hours as free; only 3,600 are.
Order contribution = 3,000 × (₹1,500 − ₹1,180) = ₹9.60 lakh.
- If B is curtailed (B ranks last per hour): opportunity cost = 8,400 × ₹133.33 = ₹11.20 lakh. Net = 9.60 − 11.20 = −₹1.60 lakh → reject at ₹1,500. Minimum price = ₹1,180 + (11,20,000 ÷ 3,000) = ₹1,553.33.
- If B's demand is contractually fixed and A is curtailed: opportunity cost = 8,400 × ₹182.50 = ₹15.33 lakh; net = −₹5.73 lakh. Minimum price = ₹1,180 + (15,33,000 ÷ 3,000) = ₹1,691.00.
Recommendation: at ₹1,500 the order destroys ₹1.60–5.73 lakh of contribution. Counter at not less than ₹1,555 (B-displacement case) and only if B volumes can genuinely be reduced without penalty; otherwise the floor is ₹1,691. The first 900 units consume only idle hours and can be priced at ₹1,180 if a partial order is negotiable.
2. The works manager proposes covering the order entirely with overtime at a 40% premium on direct labour, instead of displacing Product B. Evaluate this option and state the revised decision.
Read the worked answer
Only the premium is incremental. The ₹260 direct labour cost is already inside the ₹1,180 variable cost; overtime adds 40% × ₹260 = ₹104 per unit.
Full overtime cover: 3,000 × ₹104 = ₹3.12 lakh. Net effect = order contribution ₹9.60 lakh − ₹3.12 lakh = +₹6.48 lakh.
Better still, use the free hours first. Idle capacity absorbs 3,600 hours = 900 units. Overtime is then needed only for the remaining 2,100 units: 2,100 × ₹104 = ₹2.18 lakh, giving net benefit of ₹7.42 lakh with no displacement of B.
Revised decision: accept at ₹1,500, conditional on the overtime being genuinely available for 8,400 hours and on the premium applying only to the additional hours.
Checks before signing:
- Confirm the 40% premium is the full incremental cost - shift allowances, supervision, power and consumables on overtime are often excluded from the standard rate.
- Sustained overtime raises defect and accident rates; a 3,000-unit order is a poor reason to compromise quality on existing OEM work.
- Overtime converts a fixed-to-variable trade-off: the ₹2.18–3.12 lakh is cash out, whereas displacement is an opportunity cost. If the order is cancelled after overtime is worked, the cost is sunk.
- The break-even premium is 8,400 hours of B contribution (₹11.20 lakh) ÷ 3,000 units = ₹373 per unit of labour premium, i.e. up to about 143% premium - so the overtime route has a wide margin of safety.
3. The trading house offers a three-year agreement at ₹1,500 per unit for 3,000 units a year if the first order is accepted. How does this change your recommendation? Identify three qualitative factors and one risk the arithmetic ignores.
Read the worked answer
The arithmetic does not change much; the strategic frame does. Repeating the order three times at ₹1,500 yields roughly ₹7.42 lakh of net benefit a year on the overtime route (or a loss of ₹1.60 lakh if B is displaced each year). A three-year commitment therefore does not by itself justify a price below ₹1,553; it justifies investing in capacity - a second shift or a leased machine - which converts the opportunity cost into a fixed cost and could pull the floor towards the ₹1,180 cash cost.
Test the commitment: is it firm or a forecast? Is it indexed for wage and power inflation? Does it carry a take-or-pay minimum? A three-year price with no escalation clause at a 19% discount to list is a margin trap, not a foothold.
Qualitative factors:
- Price precedent. Existing OEM customers at ₹1,850 will learn of a ₹1,500 transaction in the same market; the reputational cost of defending list price may exceed the order margin.
- Channel conflict. The trading house supplies two of Arvon's OEM customers; helping it build a private-label position could convert a customer into a competitor.
- Capability and learning. If the modified unit uses a process Arvon wants to master (or if a learning curve cuts variable cost by, say, 8% in year two, lifting contribution to ₹414 per unit), the strategic option has value beyond the three-year cash flows.
The risk the numbers ignore: the trading house reselling under its own brand - brand dilution, warranty exposure on units Arvon did not sell, and design/IP leakage if drawings are shared. Recommend a price floor of ₹1,555, a brand/warranty clause, and a capacity decision taken separately from the pricing decision.