Garment Subcontractor Facing a Low-Price Order
A garment subcontractor in Shwepyithar has 50 sewing machines and a monthly capacity of 20,000 shirts. Fixed costs are 15 million kyat a month for rent, administration, and machine depreciation; these continue even if production stops. The regular buyer has cut its order from 12,000 to 8,000 shirts at 6,200 kyat each. A second buyer offers 6,000 shirts at 4,900 kyat each, to be delivered in the same month, using spare capacity. Cost records show total variable cost of 48 million kyat at 8,000 shirts, 60 million at 12,000, 84 million at 18,000, and 100 million at 20,000. The owner must decide whether to accept the second order, shut down for the month, or produce only the regular order. Workers are paid piece rates and can be laid off without severance; the lease cannot be cancelled.
1. Calculate contribution and profit or loss at 8,000 shirts only and at 14,000 shirts with the second order. Should the owner accept the second order if the alternative is producing only the regular order? Explain using incremental cost.
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At 8,000 shirts: Revenue = 8,000 × 6,200 = 49,600,000 kyat. Variable cost = 48,000,000 kyat. Contribution = 1,600,000 kyat. Profit = 1,600,000 − 15,000,000 = −13,400,000 kyat, a loss of 13.4 million kyat. If the firm shuts down, it still pays 15 million kyat fixed cost, so the loss is 15 million kyat. Producing the regular order is better than shutting down by 1.6 million kyat because it covers part of fixed cost.
At 14,000 shirts: Revenue = 49,600,000 + 6,000 × 4,900 = 49,600,000 + 29,400,000 = 79,000,000 kyat. Variable cost at 14,000 shirts: between 60 million at 12,000 and 84 million at 18,000, the increase is 24 million over 6,000 shirts, or 4,000 kyat per shirt. At 14,000, variable cost = 60,000,000 + 2,000 × 4,000 = 68,000,000 kyat. Contribution = 79,000,000 − 68,000,000 = 11,000,000 kyat. Profit = 11,000,000 − 15,000,000 = −4,000,000 kyat, a loss of 4 million kyat.
The second order adds revenue of 29.4 million kyat and variable cost of 20 million kyat, so it adds 9.4 million kyat of contribution. The offer price of 4,900 kyat is above the incremental variable cost of 20,000,000 ÷ 6,000 = 3,333 kyat per shirt. Fixed costs do not change. Accepting the order reduces the loss from 13.4 million to 4 million kyat, so accept it.
2. The second buyer now asks for a one-year contract at 4,900 kyat, not a one-month order. What long-run factors should the owner weigh? Would your answer change?
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In the short run, the rule is to accept any order whose price exceeds incremental variable cost and that uses otherwise idle capacity. At 14,000 shirts, average variable cost is 68,000,000 ÷ 14,000 = 4,857 kyat, so 4,900 kyat is only just above AVC. Price is below average total cost: ATC = (68,000,000 + 15,000,000) ÷ 14,000 = 5,929 kyat. A one-month order can be accepted because it contributes 9.4 million kyat toward fixed costs. A one-year contract at that price would lock in a loss of about 4 million kyat a month if 14,000 shirts is the normal volume.
Long-run factors: if the regular buyer returns to 12,000 shirts, adding 6,000 low-price shirts gives 18,000, still within 20,000 capacity. But if regular demand recovers further, the low-price contract may crowd out higher-priced work. A long contract also strengthens the buyer’s bargaining power, may set a low reference price for other buyers, and can create worker fatigue and quality risk. The owner should check whether fixed costs can be reduced, whether the lease can be renegotiated, and whether the low-price buyer will accept a price escalation clause or a shorter trial period.
My answer would change for a one-year contract: accept only if the owner expects regular demand to stay depressed, if the contract leaves enough capacity for higher-priced orders, and if it includes a review clause. Otherwise, prefer the one-month order or negotiate a price closer to ATC. Do not reject the order solely because 4,900 kyat is below ATC; do reject a long lock-in that prevents recovery.