Fernwood Furniture: An Order Priced Below Absorption Cost
Fernwood Furniture Ltd makes garden benches at a single factory. Budgeted output and sales for 2025 are 18,000 units, well below practical capacity of 24,000 units. At that budgeted level the standard absorption cost per bench is $70: direct materials $24, direct labour $16, variable overhead $6, and fixed production overhead $24, the last absorbed on budgeted units. Total fixed production overhead incurred in 2025 was $432,000 and actual production was 20,000 units, of which 18,500 were sold at $95 each. In November an overseas buyer offered to buy 3,500 benches at $62 each, a price below the absorption cost; the order needs a modified fitting and one-off tooling costing $15,000, would not affect existing sales or selling price, and would use spare capacity. Separately a domestic retailer has offered $70 for 3,000 benches, deliverable by March when only 2,000 units of free capacity remain, so 1,000 units of normal sales would be displaced; it would require extra fixed distribution costs of $6,000.
1. Calculate the profit for 2025 under marginal costing and under absorption costing and reconcile the difference. Show also the over- or under-absorption of fixed production overhead.
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Marginal costing
| $ | |
|---|---|
| Sales 18,500 × $95 | 1,757,500 |
| Variable cost 18,500 × $46 (24 + 16 + 6) | (851,000) |
| Contribution | 906,500 |
| Fixed production overhead incurred | (432,000) |
| Profit | 474,500 |
Absorption costing
Overhead absorbed = 20,000 units produced × $24 = $480,000; incurred $432,000, so overhead is over-absorbed by $48,000.
| $ | |
|---|---|
| Sales | 1,757,500 |
| Cost of sales 18,500 × $70 | (1,295,000) |
| Gross profit | 462,500 |
| Over-absorbed overhead written back | 48,000 |
| Profit | 510,500 |
Reconciliation: $510,500 − $474,500 = $36,000, which is the fixed overhead carried forward in stock: 1,500 units of closing stock × $24 = $36,000. Absorption costing defers that fixed overhead to a future period; marginal costing charges the whole $432,000 against this year's contribution. The difference exists only because stock rose; if production equalled sales the two profits would be identical.
Note that the $70 standard cost is a budget-based figure: at actual output the fixed overhead per unit is $432,000 ÷ 20,000 = $21.60, giving an actual absorption cost of $67.60, not $70.
2. Evaluate both orders using relevant costing and recommend which one, if either, should be accepted. State your capacity assumption.
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Relevant cost principle: include only future, incremental cash flows that differ between the alternatives. The $24 fixed overhead per unit is not relevant - total fixed overhead of $432,000 is incurred whether or not either order is taken.
Overseas order - 3,500 units at $62
| $ | |
|---|---|
| Incremental revenue 3,500 × $62 | 217,000 |
| Variable cost 3,500 × $46 | (161,000) |
| Contribution | 56,000 |
| One-off tooling | (15,000) |
| Net benefit | 41,000 |
Spare capacity is 24,000 − 20,000 = 4,000 units, so 3,500 units fit without displacing normal sales; no opportunity cost arises. The 1,500 units in stock are committed to normal sales and are not treated as free supply.
Domestic order - 3,000 units at $70
| $ | |
|---|---|
| Contribution 3,000 × ($70 − $46) | 72,000 |
| Extra fixed distribution costs | (6,000) |
| Lost contribution on 1,000 displaced units × $49 | (49,000) |
| Net benefit | 17,000 |
Recommendation: the two orders cannot both be taken. On the stated capacity assumption, accept the overseas order - $41,000 against $17,000. The domestic order looks better on price alone ($70 against $62), but the March deadline leaves only 2,000 units of free capacity and the lost normal contribution of $49,000 destroys most of its benefit. If the domestic order could be scheduled after March, when the full 4,000 units are free, it would yield $66,000 and would beat the overseas order - the timing, not the price, drives the decision.
3. Explain why the $24 fixed overhead is excluded from the decision, and give three qualitative factors the board should weigh before accepting an order at $62.
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Why the $24 is excluded
The $24 is not a cost caused by the order; it is an absorption rate - $432,000 of fixed production overhead spread over 18,000 budgeted units. Accepting the order does not increase that $432,000, so treating it as a cost of the order would overstate the cost of the order and reject profitable incremental business. Using full absorption cost as the decision cost answers the wrong question: absorption costing asks "what did each unit absorb?", whereas the decision asks "what changes if we say yes?". The relevant figure is the $46 variable cost plus any incremental fixed cash cost (the $15,000 tooling).
The company must still cover its fixed overhead in the long run: at $16 contribution per bench, break-even is $432,000 ÷ 16 = 27,000 units, above the 24,000-unit capacity. An order at $62 is sustainable only as a marginal filler of otherwise idle capacity, never as the normal selling price.
Qualitative factors
- Price precedent and market segmentation. If domestic customers learn that benches sell at $62, pressure on the $95 price will follow. An export order in a separate market reduces that risk; a domestic order at $70 carries it.
- Buyer and country risk. Export credit risk, payment terms, foreign exchange exposure, freight, duty and insurance may not yet be in the $62 figure; a deduction of even $4 per bench removes $14,000 of the $41,000 benefit.
- Dependence and future bargaining. A buyer who becomes a large share of output may push for further reductions. The tooling has no alternative use and locks the company into that design.
Also worth weighing: workforce stability from using the spare capacity, the reliability of the March capacity estimate, and whether the same capacity could attract a higher-priced order later in the year.