Special order with spare capacity and opportunity cost
Ceylon Components manufactures a single product and has capacity of 80,000 machine hours per year. Budgeted production uses 70,000 hours, leaving 10,000 hours spare. A foreign customer offers a one-off order for 12,000 units at LKR 1,200 per unit. Each unit needs 1 machine hour. Variable production cost is LKR 800 per unit. The order would require a special setup costing LKR 1.5 million and additional quality testing of LKR 0.4 million. To meet the delivery date, 2,000 of the 12,000 hours would have to be taken from regular output, which earns a contribution of LKR 900 per machine hour. The customer would pay after 60 days. The company's overdraft rate is 14% per year. Fixed production overhead of LKR 300 per unit is absorbed into normal product cost. The sales director says the order must be rejected because the price is below the normal selling price of LKR 1,650.
1. Calculate the relevant cost of the order and the minimum acceptable unit price. State which costs are not relevant and why.
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Relevant costs: Variable production: 12,000 x LKR 800 = LKR 9,600,000 Special setup = LKR 1,500,000 Additional testing = LKR 400,000 Opportunity cost of displaced regular output: 2,000 hours x LKR 900 = LKR 1,800,000 Financing cost: LKR 14,400,000 x 14% x 60/365 = LKR 331,507 (about LKR 0.332 million) Total relevant cost = LKR 13,631,507
Minimum price = 13,631,507 / 12,000 = LKR 1,136 per unit (rounded).
The absorbed fixed overhead of LKR 300 per unit is not relevant because it is an allocation of existing fixed cost; no additional fixed capacity cost is mentioned. The normal selling price of LKR 1,650 is not a relevant cost; it matters only for strategic and pricing effects. The offer at LKR 1,200 gives a relevant profit of about LKR 0.768 million (14.4m - 13.6315m).
2. Recommend whether to accept the order. Include the conditions you would attach.
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Accept only marginally. The margin is about LKR 0.768 million on revenue of LKR 14.4 million, or 5.3%. It is sensitive to any increase in setup, testing, financing or displaced contribution. If regular demand rises or the order needs more than 12,000 hours, the opportunity cost increases and the order may become loss-making.
Conditions: confirm the foreign customer's creditworthiness or require a letter of credit; negotiate earlier payment to reduce the LKR 0.332 million financing cost; check whether the 2,000 displaced hours can be covered by overtime at a premium below LKR 1.8 million; and confirm that accepting a low price will not trigger price pressure from regular customers. Do not reject the order merely because it is below normal selling price or below absorption cost.
3. Identify the qualitative factors that could overturn the financial conclusion.
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The calculation is only a starting point. Consider: capacity risk if the order disrupts regular customers; quality risk from rushed production and additional testing; foreign exchange risk and credit risk on the 60-day receivable; learning effects that may reduce future costs; and strategic value if the customer opens a new export market.
Also consider whether the LKR 1,200 price is a one-off or the start of a lower market price. If regular customers learn of the price, the company may face pressure to reduce normal prices. If the order uses scarce skilled labour, the opportunity cost may be understated. Reject if credit risk, quality risk or long-term price erosion outweighs the thin margin.