Special order with a capacity constraint
Delimara Components Ltd makes a single component and is currently producing 9,000 units a year against a practical capacity of 10,000. The normal selling price is €25 per unit and variable costs are €11 per unit. Fixed production overheads are €120,000 a year and are absorbed at €12 per unit at normal capacity. An overseas distributor has offered to buy 2,000 units at €18.50 each. Accepting the order would use the 1,000 units of spare capacity and would also require cutting regular sales by 1,000 units, because the extra 1,000 units cannot be made without displacing existing production. The order would need a special mould costing €4,000 with no resale value and an additional part-time supervisor costing €2,500. Last year the company spent €9,000 designing a variant of the component that the distributor has now asked for. The sales director says the order should be rejected because €18.50 is below the €23 full cost per unit.
1. Prepare a relevant cost statement for the special order and recommend whether it should be accepted.
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Relevant cost statement for 2,000 units
| Item | € |
|---|---|
| Revenue (2,000 × €18.50) | 37,000 |
| Variable costs (2,000 × €11) | (22,000) |
| Special mould | (4,000) |
| Additional supervisor | (2,500) |
| Opportunity cost: lost contribution on 1,000 regular units (1,000 × (€25 − €11)) | (14,000) |
| Net relevant benefit/(cost) | (5,500) |
The order reduces profit by €5,500, so it should be rejected on financial grounds. The €9,000 design cost is sunk and irrelevant. If the 2,000 units could be made entirely from spare capacity, the opportunity cost would disappear and the order would show €8,500 positive (€15,000 contribution − €6,500 specific fixed costs). The capacity constraint is therefore decisive.
2. Explain why the sales director's comparison with the €23 full cost per unit is misleading, and why the opportunity cost must nevertheless be included.
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The €23 full cost includes €12 of absorbed fixed overhead per unit. The company's fixed overhead total of €120,000 does not change if the order is accepted, apart from the specific €2,500 supervisor, so charging €24,000 of existing fixed overhead to the order is not a relevant cost. Relevant costing includes only future cash flows that differ between the alternatives.
The €9,000 design cost was incurred last year and cannot be recovered, so it is sunk. It should not influence the decision.
The order is not, however, free of capacity cost. Making 2,000 units uses the 1,000 units of spare capacity and displaces 1,000 regular units, each earning €14 contribution. That €14,000 lost contribution is a real opportunity cost because it is the benefit sacrificed by choosing the special order. Comparing €18.50 with an absorption cost per unit hides both the irrelevance of existing fixed overhead and the relevance of the lost regular sales. The correct comparison is between relevant benefits and relevant costs, not between the offer price and a full cost.
3. Calculate the minimum unit price at which the order would be financially worthwhile, and identify two non-financial factors the directors should consider.
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Required revenue = variable costs €22,000 + mould €4,000 + supervisor €2,500 + opportunity cost €14,000 = €42,500.
Minimum unit price = €42,500 ÷ 2,000 = €21.25.
At €21.25 the order breaks even in relevant terms. Any price above €21.25 adds profit; any price below it reduces profit.
Non-financial factors include:
- Future business with the distributor. A low-priced first order may lead to repeat business at normal prices, although there is no guarantee.
- Reusability of the mould and the design. If the €4,000 mould can be used for later orders, its relevant cost is lower, and the minimum price falls.
- Damage to regular customer relationships. Displacing 1,000 units may cause regular customers to go elsewhere permanently.
- Capacity expansion. The company could consider a third shift or outsourcing to remove the constraint, but that would require a separate investment appraisal.