Meridian Components: Product Mix and a Special Order at the Bottleneck
Meridian Components runs a single five-axis CNC cell that is the plant's binding constraint: 20,000 machine hours are available each year and demand already exceeds them. It makes two parts. Part A sells for $85, uses $28 of material, $12 of direct labour and $8 of variable overhead, and takes 0.5 machine hours. Part B sells for $140, uses $52 of material, $18 of labour and $10 of variable overhead, and takes 1.2 machine hours. Maximum annual demand is 30,000 A and 12,000 B. Fixed costs of $1,000,000 are absorbed at $50 per machine hour. The sales director has planned next year's output to protect existing customer relationships at 24,000 A and 6,667 B. An overseas distributor has offered to buy 3,000 units of a simplified A at $64 each; the specification change saves $4 of material per unit but adds inspection time, taking each unit to 0.6 machine hours. Separately, the sales director wants to drop Part B because at full absorption cost it 'makes no profit'.
1. Compute the optimal product mix and the contribution at the sales director's proposed mix. Explain the ranking rule you used and why unit contribution is the wrong basis.
Read the worked answer
Rank by contribution per machine hour (the scarce resource), not by unit contribution or selling price.
- Part A: ($85 - 28 - 12 - 8) / 0.5 = $37 / 0.5 = $74 per hour
- Part B: ($140 - 52 - 18 - 10) / 1.2 = $60 / 1.2 = $50 per hour
Unit contribution favours B ($60 vs $37) and selling price favours B ($140 vs $85); both are wrong, because B consumes 2.4 times the constraint hours. Supply A first up to its demand ceiling.
Optimal mix. A: 30,000 units = 15,000 hours, contribution $1,110,000. Remaining hours 5,000 / 1.2 = 4,166 whole units of B (half a unit cannot be sold), contribution $249,960. Total contribution $1,359,960; less fixed costs $1,000,000 = profit $359,960.
Sales director's plan. 24,000 A uses 12,000 hours ($888,000 contribution); 6,667 B uses 8,000 hours ($400,020). Total contribution $1,288,020, profit $288,020. The plan costs $72,000 a year relative to the optimum and, at 20,000.4 hours, is marginally infeasible without overtime.
The $72,000 is the price of protecting eighteen months of customer relationships. That may be a defensible purchase - but it should be presented to the board as a deliberate $72,000 spend with a named benefit, not as a neutral planning choice. Customer relationships are also not symmetrical: losing a B customer may cost future A volume, which is exactly the kind of effect the model excludes.
2. Evaluate the special order. Show the correct comparison, the net effect, and the minimum acceptable price.
Read the worked answer
Unit contribution of the order: $64 - $24 material - $12 labour - $8 variable overhead = $20 per unit; 3,000 units = $60,000, using 1,800 machine hours.
The trap. Two shortcuts both give the wrong answer: comparing $20 with A's $37 and rejecting on a unit basis, or comparing $20 with the plant average and accepting because it is positive. The constraint is fully used, so the order is not incremental - accepting it displaces existing output.
Correct comparison: the product displaced at the margin. In the optimal mix the last hours are worked by B at $50 per hour. Displaced contribution = 1,800 x $50 = $90,000. Net effect = $60,000 - $90,000 = -$30,000. Reject.
Minimum acceptable price. Contribution required = 1,800 x $50 / 3,000 = $30 per unit. Floor price = $24 + $12 + $8 + $30 = $74. The offer of $64 is $10 short, and reaching $74 would only make the order neutral.
Qualitative factors that could justify acceptance below $74:
- The hours fall in a seasonally slack month, so nothing is displaced and the test reverts to $20 > 0 - the contribution approach, correctly applied to slack capacity.
- The order is a market-entry trial with credible follow-on volume at full price; value the option explicitly rather than assuming it.
- The simplified specification may be a platform for a standard product with lower cost.
Check before accepting: that the simplified part does not cannibalise A's branded market through the distributor, and that no existing distribution agreement grants territorial exclusivity.
3. Critically evaluate the proposal to drop Part B, using the absorption-cost figures the sales director relies on, and state what would change your conclusion.
Read the worked answer
What the absorption view shows. Part A full cost = $28 + $12 + $8 + (0.5 x $50) = $73, profit $12. Part B full cost = $52 + $18 + $10 + (1.2 x $50) = $140, profit nil. On that basis B 'adds nothing' and should go.
Why it misleads. The $50 per hour is a method of spreading $1,000,000 of fixed cost, not a cost incurred by making B. Dropping B does not remove any of that $1,000,000 in the short run. The test is what happens to total contribution.
The arithmetic. Dropping B releases 8,000 hours (6,667 units x 1.2). The released hours have nowhere to go: A's demand is capped at 30,000 and only 6,000 more A can be sold, using 3,000 hours. Output becomes 30,000 A, contribution $1,110,000, profit $110,000 - a fall of $249,960 from the optimum and $178,020 from the current plan. Five thousand hours sit idle, and with them $250,000 of contribution.
The deeper point. B is the marginal product: its $50 per hour is precisely what sets the floor price for special orders. Remove B and the floor falls to zero on idle hours, which is how plants end up filling capacity with loss-making orders.
What would change the conclusion:
- A permanent fall in B's price or rise in material cost that pushes contribution per hour to zero or below.
- A new product with contribution per hour above $50 that can absorb the hours and whose demand is verified.
- A strategic exit decision, in which the avoidable fixed costs, dedicated tooling and lost customer lifetime value must be quantified - an exit is a capital decision, not a costing decision.
- A quality or delivery problem on B that is eroding A's customer relationships.