Rivergum Bakery: the hotel contract that full cost rejects
Rivergum Bakery bakes 16,000 loaves a month at an average retail price of $6.50. Variable cost is $3.20 a loaf (ingredients, packaging, energy) and fixed costs are $36,000 a month. Practical capacity is 20,000 loaves a month on one shift; the two permanent bakers can handle 18,000, beyond which a casual must be paid $0.35 a loaf on every loaf above 18,000.
A hotel group offers a six-month contract for 4,000 loaves a month at $4.40, delivered. Delivery requires leasing a second van at $1,400 a month. The group will not accept a trial or a volume that changes month to month.
At the management meeting the accountant objects: "Full cost is $3.20 plus $36,000 over 16,000 loaves - $5.45 each. At $4.40 we lose $1.05 a loaf, or $25,200 over the contract. Reject it." The owner notes that December retail demand reaches 19,500 loaves and says the contract "makes December impossible anyway".
1. Test the accountant's conclusion with a relevant-cost analysis and explain why the two figures disagree so sharply.
Read the worked answer
Only costs that change because of the contract belong in the decision.
| Item (per month) | $ |
|---|---|
| Incremental revenue, 4,000 × $4.40 | 17,600 |
| Incremental variable cost, 4,000 × $3.20 | (12,800) |
| Contribution before step costs | 4,800 |
| Casual labour, 2,000 loaves above 18,000 × $0.35 | (700) |
| Second van lease | (1,400) |
| Net incremental benefit | 2,700 |
So the contract adds $2,700 a month, $16,200 over six months, and should be accepted on financial grounds.
The accountant's $5.45 includes $2.25 of allocated fixed cost. The $36,000 is unchanged whether or not the contract is signed, so spreading it over the new loaves is bookkeeping, not cash. The disagreement is not arithmetic; it is that absorption costing answers "what does a loaf cost on average?" while the decision asks "what changes if we say yes?". The two answers diverge whenever capacity is idle.
2. Deal with December. Quantify what the contract costs in that month and state the minimum price or volume that would make taking the full 4,000 acceptable.
Read the worked answer
In December, retail demand alone is 19,500, leaving room for only 500 hotel loaves before the 20,000 capacity ceiling. Taking the full 4,000 therefore means producing 20,000 and displacing 3,500 retail loaves, each carrying $6.50 − $3.20 = $3.30 of contribution.
December incremental result: 4,800 − 700 − 1,400 − (3,500 × 3.30) = 4,800 − 2,100 − 11,550 = −$8,850. One bad month wipes out more than three good ones.
Break-even price for full volume in December: 4,000(p − 3.20) = 700 + 1,400 + 11,550 = 13,650, so p = $6.61. That is above the retail price, so no realistic renegotiation works at 4,000 loaves.
The better lever is volume, not price: at 500 loaves the contract earns 500 × $1.20 = $600 and displaces nothing. Note that the $700 labour step is triggered by retail demand alone, so it is not attributable to the contract in December. Recommend accepting the contract conditional on a 500-loaf December, and be prepared to trade some of the $16,200 to secure that term.
3. The owner adds: "And if we become the hotel's supplier, our retail customers will expect hotel prices." Identify which of these considerations are decision-relevant and how you would test them.
Read the worked answer
This is a qualitative claim that may or may not be true, and the analysis above gives a clear benchmark against which to test it: the contract is worth $16,200, so any qualitative objection must plausibly destroy more than that to justify rejecting it.
Decision-relevant, and testable: (1) Price leakage - does the hotel resell or serve the loaves in a way retail customers can see, and does the $4.40 price become known? Baking a plain sandwich loaf and selling it through a hotel kitchen is a different market from a shopfront; the risk is real but modest. Check by asking how the hotel will use and label the product. (2) Capacity reliability - a six-month contract with penalty clauses, on equipment already at 80% utilisation, risks the retail trade that funds everything. Check the contract's remedies for shortfall and the ovens' maintenance history. (3) Commitment - the $1,400 van becomes a committed fixed cost once signed; it is avoidable now and not avoidable later.
Not decision-relevant unless evidenced: general unease about "brand dilution". The owner should be asked what specifically would change, and what evidence exists. If none, it is a preference, not a cost, and should be priced explicitly rather than used to veto a $16,200 gain.