The Loss-Making Line and the Export Enquiry
Sundar Polymers makes industrial drums (Line A) and consumer crates (Line B). Last year Line A earned a segment result of ₹0.40 crore on revenue of ₹4.20 crore; Line B showed a loss of ₹0.45 crore on revenue of ₹1.80 crore. Line B's variable cost is ₹1.35 crore, its avoidable fixed cost is ₹0.55 crore, and ₹0.35 crore of corporate overhead is apportioned to it. The company as a whole posted a small loss of ₹0.05 crore. Line A has no spare capacity; Line B currently runs at about 70% of its installed 200,000-unit capacity. At the board meeting the CFO tabled a proposal to exit crates and 'stop destroying ₹45 lakh a year'. Separately, a Middle-East distributor has enquired for 40,000 crates at ₹310 per unit against a normal domestic price of ₹450. Variable cost per crate is ₹240 and export packaging adds ₹40. A dedicated mould costing ₹9 lakh would be needed. The distributor wants 90 days' credit against the 30 days given domestically, and working capital costs 12% a year.
1. Should the company exit Line B? Show the relevant computation and state the conditions under which your answer would flip.
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Relevant test: what changes if Line B disappears.
| Item | ₹ crore |
|---|---|
| Revenue forgone | 1.80 |
| Variable cost saved | (1.35) |
| Contribution lost | 0.45 |
| Avoidable fixed cost saved | 0.55 |
| Net effect of exit on profit | +0.10 improvement |
The allocated ₹0.35 crore of corporate overhead is not avoidable and must be excluded from the decision; it will simply be re-apportioned onto Line A, making Line A look worse after the exit and inviting a second wrong decision.
On the face of it, exit improves profit by ₹0.10 crore, turning a ₹0.05 crore loss into a ₹0.05 crore profit. But the answer flips on four conditions:
- Is the ₹0.55 crore genuinely avoidable? If Line B shares the building, a compressor, or a supervisor with Line A, much of it may be escapable only if the plant is sold or the space re-let.
- Can the space be sold, re-let, or redeployed at a return above ₹0.45 crore of contribution? If the space is worth more than ₹0.45 crore a year to Line A or a tenant, exit is clearly right.
- Customer bundling. If crate buyers are also drum buyers, exit may cost Line A volume - a contribution loss the analysis ignores.
- Reversibility. Exiting forfeits the ₹0.45 crore contribution as a platform for future recovery. With 30% spare capacity, a modest price recovery would make the line worth more than its exit value.
The honest conclusion: exit is marginally value-creating on these numbers alone, but a ₹0.10 crore swing on a ₹6 crore business is thin. Before exiting, ask whether 30% idle capacity could be filled rather than shut.
2. Evaluate the 40,000-unit export enquiry at ₹310. Should it be accepted? Set out the full incremental analysis, including the mould and the credit terms.
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Step 1 - unit contribution. Price ₹310 less variable cost ₹240 less export packaging ₹40 = ₹30 per unit. On 40,000 units that is ₹12 lakh.
Step 2 - the mould. It is incremental and specific to this order: ₹9 lakh. If it has no other use, net becomes ₹3 lakh. If it is reusable across repeat orders, amortise it over the expected order life instead - this single assumption can flip the decision.
Step 3 - the credit cost, which is the step most candidates miss. The order value is 40,000 × ₹310 = ₹1.24 crore. Export credit is 90 days against 30 domestically, so 60 extra days of funding are required at 12%: 1.24 × 0.12 × 60/365 = ₹2.45 lakh.
Step 4 - net result. ₹3.00 lakh − ₹2.45 lakh = ₹0.55 lakh. Essentially zero.
Step 5 - capacity check. 40,000 units fits inside the 60,000 units of idle capacity, so no domestic contribution is displaced. If it did displace domestic sales at ₹450, the opportunity cost of ₹210 per unit would kill the order instantly.
Judgement. On a one-off basis, reject or renegotiate: ₹0.55 lakh is inside the error margin of the packaging and freight estimates. Accept if (a) the mould is reusable over repeat orders, so the ₹9 lakh spread over say three orders makes each one clearly profitable; (b) the distributor commits to volume beyond the first tranche; or (c) payment can be secured by an irrevocable letter of credit, which cuts both credit risk and the financing cost. Also price the credit explicitly: asking ₹325 instead of ₹310 would add ₹6 lakh of contribution and make the order unambiguously attractive.
3. The CFO argues that no order should ever be accepted below full cost, including a share of corporate overhead, because 'every unit must pay for the company'. Evaluate this policy for a firm with idle capacity in one line.
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Where the CFO is right. A standing policy of pricing every order at full cost protects against the slow drift into marginal-cost pricing, where a firm fills capacity with low-price work and then cannot fund replacement assets, R&D or overhead. It also protects against sales teams discounting routinely while calling each case 'incremental'. For long-run, repeat, core-volume business, full cost is the correct floor.
Where the policy is wrong. Corporate overhead is not caused by any individual order. Charging it to a marginal order means the firm will reject orders that genuinely add cash - and with Line B running at 70% of capacity, rejected contribution is permanently lost, while the overhead is incurred anyway. The correct floor for a genuinely one-off order using otherwise idle capacity is the incremental cost plus any opportunity cost of the capacity used. The full-cost rule is a pricing discipline, not a decision rule.
How to reconcile. Adopt a two-tier policy and write it down: (1) core and repeat business must clear full cost plus a target return; (2) fill-in business on demonstrably idle capacity may be priced above incremental cost, subject to three gates - no displacement of full-price volume, no risk of the price becoming the reference price, and no capacity committed beyond the current planning horizon.
On these facts, the export enquiry passes the gates but barely clears the incremental floor. That is a signal the price is too low, not that the CFO's policy is right. The board should reject the policy and renegotiate the order.