Special order with a filling-line bottleneck at a coconut processor
Ceylon Coconut Foods PLC operates a single filling line in Kurunegala. Monthly capacity is 10 million 400 ml cans, and current external sales are 9.2 million cans at LKR 310 per can. Variable costs are LKR 185 per can, and a 5% sales commission is paid on external sales. Fixed factory costs are LKR 450 million per month and do not change with this decision. A distributor in the Middle East has offered to buy 2 million cans at LKR 240 per can, ex-factory, for a one-off private-label order. The order would require additional packaging at LKR 8 per can, one-off tooling of LKR 12 million, and overtime premium of LKR 6 million. The distributor will not pay sales commission. The order must be accepted or rejected in full; the plant cannot expand capacity before the order is due. The sales director argues that the order 'still makes LKR 47 per can' and should be accepted to use spare capacity.
1. Calculate the relevant cost and benefit of accepting the Middle East order. Show contribution, incremental costs and opportunity cost, and recommend whether to accept.
Read the worked answer
Start with the normal contribution per can, because displaced sales create the real cost:
- Normal selling price: LKR 310
- Variable cost: LKR 185
- Sales commission: 5% x 310 = LKR 15.50
- Normal contribution: 310 - 185 - 15.50 = LKR 109.50 per can
Spare capacity is 10m - 9.2m = 0.8m cans. A 2m order therefore displaces 1.2m normal cans. The opportunity cost is 1.2m x 109.50 = LKR 131.4m.
The special order's own contribution is:
- Price: LKR 240
- Variable cost: LKR 185
- Extra packaging: LKR 8
- Special contribution: LKR 47 per can
- Total contribution: 2m x 47 = LKR 94m
Less one-off tooling LKR 12m and overtime LKR 6m gives LKR 76m before opportunity cost. Deduct LKR 131.4m, giving a net disadvantage of LKR 55.4m. Fixed factory costs are irrelevant because they do not change. Recommendation: reject the order on financial grounds. The sales director's 'LKR 47 per can' ignores the contribution lost on 1.2m cans that would have been sold at the normal price.
2. At what special price per can would the order break even, assuming the same displacement and costs? Comment on whether that price is commercially realistic.
Read the worked answer
Let P be the special price. Special contribution per can is P - 185 - 8 = P - 193. The order is 2m cans, so total special contribution is 2m(P - 193). Break-even requires this to cover the incremental fixed costs of LKR 18m (12m tooling + 6m overtime) and the opportunity cost of LKR 131.4m:
2m(P - 193) - 18m - 131.4m = 0 2m(P - 193) = 149.4m P - 193 = 74.70 P = LKR 267.70 per can
At LKR 267.70 the order adds no profit but also no loss. The offered LKR 240 is LKR 27.70 below break-even. Commercially, LKR 267.70 is about 86% of the normal LKR 310 price. That may be attainable in a private-label negotiation, but it is still a discount that could set a precedent, annoy existing distributors and invite repeat demands. It also leaves no margin for forex movements, quality claims or overtime overruns. A价格 above break-even would be needed to compensate for those risks.
3. If the distributor reduced the order to 1.5 million cans, would the decision change? Show the revised opportunity cost and discuss two qualitative factors.
Read the worked answer
With 1.5m cans, spare capacity of 0.8m is used first and only 0.7m normal cans are displaced. The revised opportunity cost is 0.7m x 109.50 = LKR 76.65m. Special contribution is 1.5m x 47 = LKR 70.5m. After tooling and overtime of LKR 18m, the order yields LKR 52.5m before opportunity cost. Deduct LKR 76.65m, giving a net disadvantage of LKR 24.15m. The order should still be rejected on financial grounds, although the loss is smaller.
Qualitative factors matter. First, market entry: the Middle East distributor could provide a platform for later branded sales, but private-label production may commoditise the product and weaken the brand. Second, price precedent and customer reaction: if existing distributors learn of a LKR 240 price, they may demand reductions, eroding the LKR 109.50 normal contribution. Other factors include reliability of the distributor, payment risk, foreign-currency exposure, overtime fatigue and the risk that tooling has no alternative use. These factors would need to be strong enough to justify accepting a negative net contribution, which is unlikely without a binding longer-term agreement.