The ₹185 Kenyan Order: A Marginal Costing Decision
Sundaram Industries, a Madurai maker of steel furniture, has a single-shift capacity of 1,00,000 chairs a year and currently makes and sells 60,000 at ₹250 each. The cost sheet shows direct material ₹100, direct labour ₹35 and variable overhead ₹25 per chair, and fixed overhead of ₹48 lakh a year, giving a full cost of ₹240 and a profit of about ₹6 lakh. A buyer in Kenya offers to take 45,000 chairs at ₹185 each, delivered at Tuticorin, which would add ₹5 per chair in packing and freight; no commission is payable on exports. The Works Manager says 1,05,000 chairs cannot be made on one shift. He can add a second shift, which raises capacity to 1,30,000 chairs but adds ₹6 lakh a year in fixed cost. The domestic distributors have warned that if they learn of the ₹185 price they will demand a matching reduction.
1. Compute the full cost per chair and the contribution per chair on the export order. Why can a price below full cost still be worth accepting?
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Full cost and present profit:
- Variable cost = 100 + 35 + 25 = ₹160 per chair.
- Fixed cost recovery = 48,00,000 / 60,000 = ₹80 per chair.
- Full cost = ₹240; profit = ₹250 − ₹240 = ₹10 per chair, or ₹6,00,000 in total.
- Contribution per domestic chair = 250 − 160 = ₹90.
Export order:
- Incremental variable cost = 160 + 5 (packing and freight) = ₹165.
- Contribution = 185 − 165 = ₹20 per chair, i.e. ₹9,00,000 on 45,000 chairs.
Why accept a price below ₹240: fixed overhead of ₹48 lakh is a period cost that will be incurred whether or not the order is taken, provided spare capacity exists. Pushing ₹80 of it onto each export chair makes the order look like a ₹55 loss per unit, but no extra fixed cost and no extra rupee of overhead is caused by the export. What matters is whether the price covers the incremental cost of ₹165 and adds something to profit. At ₹185 it adds ₹20 a chair, so profit rises. The floor is ₹165 only while capacity is idle; once the order displaces domestic sales, the floor must include the contribution given up.
2. Should the company accept the order, and should it run the second shift? Show the profit under each alternative.
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Option 1 - Reject the order: profit stays at ₹6,00,000.
Option 2 - Accept, one shift only: capacity is 1,00,000, so the company must produce 55,000 domestic + 45,000 export. Lost domestic sales = 5,000 chairs × contribution ₹90 = ₹4,50,000 sacrificed. Export contribution = 45,000 × ₹20 = ₹9,00,000.
- Net gain = 9,00,000 − 4,50,000 = ₹4,50,000.
- Profit = 6,00,000 + 4,50,000 = ₹10,50,000.
Option 3 - Accept and run the second shift: all 60,000 domestic chairs are supplied and the 45,000 export chairs are additional. Extra fixed cost of ₹6,00,000 is now a relevant cost.
- Net gain = 9,00,000 − 6,00,000 = ₹3,00,000.
- Profit = ₹9,00,000.
Advice: accept the order, but do not run the second shift yet - Option 2 gives ₹1,50,000 more than Option 3. Before committing, check whether the 5,000 domestic chairs are genuinely lost or can be delivered a few weeks later; if delivery can be deferred, the opportunity cost disappears and the gain becomes the full ₹9,00,000. The second shift becomes rational only when export volumes beyond 45,000 are in sight, so that the ₹6 lakh is spread over more units - or when domestic demand grows enough to use the capacity anyway.
3. At what export price does the order stop being worthwhile? State two qualitative factors that could overturn the numerical answer.
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Minimum acceptable price (one shift, displacing 5,000 domestic chairs): the export contribution must at least equal the domestic contribution sacrificed, ₹4,50,000, over 45,000 chairs - that is ₹10 per chair above the incremental cost of ₹165, so the floor is ₹175. At ₹175 the order neither adds nor subtracts profit; below ₹175 it destroys value. If the 5,000 domestic chairs can be deferred rather than lost, the floor drops to ₹165. If the second shift is run, the additional ₹6,00,000 fixed cost requires a contribution of at least ₹13.33 per chair over 45,000 units, so the floor rises to about ₹178.33.
Qualitative factors:
- Distributor reaction. The distributors have already threatened to demand the export price. Every ₹1 cut on 60,000 domestic chairs costs ₹60,000 - a ₹5 concession wipes out most of the ₹4,50,000 gain. If the export price cannot be kept confidential (and export prices usually leak), the order may cost more than it earns.
- Market and execution risk. Export incentives such as RoDTEP or duty drawback improve realisation and should be added to the ₹185 comparable; conversely, invoicing in foreign currency, freight escalation, marine insurance and quality claims in a new market can each absorb the thin ₹20 margin. A rejected container can turn the whole order negative.