The hotel group order at Medway Furniture Ltd
Medway Furniture Ltd makes office chairs in a single factory with a practical capacity of 10,000 chairs a year. Budgeted production and sales for 2025 are 7,000 chairs at €120 each. The standard unit cost at that volume is: direct materials €28, direct labour €24, variable production overhead €8, variable selling and distribution €6, and fixed production overhead €20 (€140,000 absorbed over 7,000 chairs), giving €86 and a profit of €34 per chair.
A hotel group has offered a one-off order of 2,000 chairs at €75 each, collected from the factory. The chairs need an embroidered logo, adding €4 of material per chair, and the order requires hiring a specialist machine for three months at €18,000. Production workers are paid a fixed weekly wage and the order can be made in normal hours using spare capacity; no variable selling cost arises because the group collects the chairs itself.
The management accountant has prepared a schedule showing a full cost of €84 per chair and a loss of €9 each. The sales manager says the order should be refused because it undermines the price list.
1. Prepare a relevant costing statement for the order and recommend, on financial grounds, whether it should be accepted.
Read the worked answer
Only cash flows that change because of the order belong in the statement.
| € | |
|---|---|
| Incremental revenue: 2,000 x €75 | 150,000 |
| Direct materials: (28 + 4 logo) = €32 x 2,000 | (64,000) |
| Variable production overhead: €8 x 2,000 | (16,000) |
| Specialist machine hire | (18,000) |
| Net incremental benefit | 52,000 |
Excluded, with reasons:
- Direct labour €24 x 2,000 = €48,000. Workers are on fixed weekly wages and the order fits into spare capacity in normal hours. The wage bill is unchanged, so no incremental cost arises. If overtime or extra staff were needed, the premium or extra wages would be included.
- Fixed production overhead €20 x 2,000 = €40,000. The €140,000 is incurred whether or not the order is made. Absorbing a share of it into the order does not make it a cost of the order; it merely spreads an unchanged total over more chairs.
- Variable selling and distribution €6 x 2,000 = €12,000. The group collects, so these costs are not incurred.
Recommendation: accept. The order contributes €52,000 towards fixed costs and profit that would otherwise not be earned, and it uses capacity that is currently idle. The accountant's €84 full cost and €9 loss per chair are misleading for a one-off decision because they load €20 of unchanged fixed overhead onto the order.
2. The sales manager objects that accepting €75 will undermine the €120 price list and that existing customers will demand the same deal. How should the board weigh this against the €52,000 contribution?
Read the worked answer
The financial arithmetic says accept, but the board must test whether the €52,000 survives the commercial consequences.
Points in favour of accepting:
- The order is genuinely one-off and goes to a customer outside the existing market; existing office-chair customers are unlikely to be offered hotel-logo seating.
- There is spare capacity of 3,000 chairs, so no existing order is displaced.
- The contribution is identifiable and large relative to the risk.
Points of caution:
- If the hotel group or its purchasing agent also buys standard chairs, or if the deal becomes known in the trade, the €75 can become the reference price. Losing €45 per chair on 7,000 existing chairs (€315,000 of revenue) would dwarf the €52,000.
- If the group returns next year expecting €75 as a standing price, the order stops being incremental. Repeat business must be priced on full cost plus a margin, not on spare-capacity logic.
- The machine is hired for three months, so a second order in that window would carry no further hire cost, which strengthens the case for accepting now.
- Capacity must genuinely remain spare: if demand from existing customers recovers towards 10,000 chairs, the hotel order would displace profitable sales at €120 and the analysis collapses.
A sensible board decision is to accept, with the order documented as a one-off, a distinct product specification, and a clear agreement that it does not set a price for repeat business. The board should also confirm in writing that existing customers will not be offered the same terms.
3. A director asks: 'If we ignore fixed overhead for this order, why do we bother absorbing it at all?' Explain the role of full cost, and when the €84 figure becomes the right basis for a decision.
Read the worked answer
Absorption is not wrong; it answers a different question.
What absorption does. Dividing €140,000 by 7,000 chairs gives €20 per chair so that each chair sold carries its share of factory rent, supervision and depreciation. This is essential for valuing inventory, for measuring the profit of the business as a whole, and for setting normal selling prices that recover total costs over the long run. Without it, the company would have no idea whether €120 is a sustainable price.
Why it fails for this decision. The absorption rate depends on volume: at 9,000 chairs the rate would be 140,000/9,000 = €15.56, not €20. A figure that changes with volume cannot be the marginal cost of making one more chair. Fixed overhead is a period cost that does not move with this order, so including it in the decision would reject a €52,000 contribution and leave the capacity idle.
When €84 is the right basis. Full cost is the correct test when the decision commits the company for the long run or changes the fixed cost base:
- a repeat annual contract that would need a second shift, extra supervisors or a bigger factory;
- a decision to enter the hotel market permanently, which brings design, marketing and administration costs;
- deciding whether to keep the chair line at all.
In short: full cost for pricing and long-run decisions, relevant cost for one-off, spare-capacity decisions.