Fenwick Precision: Scarce Capacity and a Special Order
Fenwick Precision operates a CNC machine shop with 24,000 machine hours available each year. Demand currently fills all capacity: 6,000 units of component X, each using 2.0 machine hours and earning a contribution of £30, and 8,000 units of component Y, each using 1.5 machine hours and earning a contribution of £18. Fixed production overhead of £480,000 is absorbed at £20 per machine hour. A customer has offered a one-year contract for 1,500 units of a new component Z at £95 per unit. Each Z would use 1.8 machine hours and £58 of variable cost, and the contract would require one-off tooling expenditure of £12,000 that has no resale value. Z would have to be made by reducing output of X or Y, since no extra machine capacity is available. Fenwick's sales director says the order should be rejected because £95 is below the full absorbed cost of the component.
1. Calculate the relevant cost and minimum price of the Z contract, and recommend whether to accept it.
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Full absorbed cost of Z (the sales director's figure): variable £58 + overhead 1.8 × £20 = £36 + tooling £12,000 ÷ 1,500 = £8, giving £102. On that basis £95 looks like a loss.
Relevant costing. The fixed overhead absorption is irrelevant: the £480,000 is unchanged whether or not Z is made. The relevant costs are the variable cost, the tooling, and the contribution forgone on the displaced product.
Contribution per machine hour:
- X: £30 ÷ 2.0 = £15.00 per hour
- Y: £18 ÷ 1.5 = £12.00 per hour
To free capacity, Fenwick should sacrifice the product with the lower contribution per hour, which is Y. Z needs 1,500 × 1.8 = 2,700 hours, displacing 2,700 ÷ 1.5 = 1,800 units of Y.
| Relevant cost | £ |
|---|---|
| Variable cost, 1,500 × £58 | 87,000 |
| Tooling | 12,000 |
| Opportunity cost, 2,700 hours × £12 | 32,400 |
| Total | 131,400 |
Minimum price = 131,400 ÷ 1,500 = £87.60 per unit.
At £95 the contract generates £142,500 of revenue and a net benefit of £11,100 above all relevant costs. Recommendation: accept, subject to confirming the displacement is genuinely Y and that Y's customers can be managed without lasting damage. The decision adds only £11,100, so it is marginal and sensitive to any error in the estimates.
2. The customer asks whether Fenwick could supply 1,500 units without reducing existing output. A machine can be leased for £40,000 a year, adding 3,000 hours. Evaluate this option.
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With leased capacity there is no displacement, so the opportunity cost of £32,400 disappears but £40,000 of lease cost appears.
| Displace Y | Lease capacity | |
|---|---|---|
| Revenue | 142,500 | 142,500 |
| Variable cost | (87,000) | (87,000) |
| Tooling | (12,000) | (12,000) |
| Opportunity cost of Y | (32,400) | – |
| Lease cost | – | (40,000) |
| Net benefit | 11,100 | 3,500 |
On these figures leasing is worse by £7,600 and should be rejected if the only alternative is to displace Y. The lease costs £40,000 to avoid a £32,400 sacrifice, so it destroys value unless it delivers something extra.
That something extra matters. Leasing keeps Y's customers supplied, avoids a possible reputation loss from cutting deliveries, and leaves 300 spare hours (3,000 less 2,700) that could be sold. If Y's customers are strategic, or if losing them risks future X and Y orders worth more than £7,600, the lease becomes defensible. The decision therefore turns on the value of customer continuity, not on the arithmetic alone.
A further test: the £3,500 net benefit under leasing is only 2.5% of revenue. A small error in the Z variable cost or in demand for Y would wipe it out, so the lease should only be signed if it can be exited at short notice and if the 300 spare hours have a realistic prospect of being sold.
3. Identify the qualitative and strategic factors the board should weigh, and explain how these might change the pricing judgement for a longer-term contract.
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The calculation gives a floor, not a price. Several factors sit outside it.
- Customer and competitor reaction. Making Z by cutting Y deliveries signals unreliability to Y's customers. If they dual-source in response, Fenwick loses the full £12 per hour contribution on Y permanently, far outweighing £11,100.
- Learning and future business. The 1,500 units are a first order. Unit variable cost and the 1.8-hour cycle time should fall with learning, so a price near £87.60 may be acceptable as an entry price if it leads to repeat volume.
- Tooling and sunk cost. The £12,000 tooling is only relevant because it has no resale value; in a multi-year contract it would be spread over far more units, which lowers the average unit cost and makes a lower price viable.
- Capacity and risk. The analysis assumes 24,000 hours are fully available. Downtime, rejects or the customer's delivery deadlines could force overtime at premium rates, eroding the £11,100.
- Strategic fit. If Z builds capability in a growing market or uses the shop's existing skills, a lower initial price may be justified; if it is a commodity order from a price-driven buyer, Fenwick gains little.
For a three-year contract the pricing logic shifts from incremental to full recovery. Recurring volume should carry its share of the fixed overhead and any new capacity it requires, not just the opportunity cost of one year's displaced work. The board should model the contract at full cost plus a target return, use the £87.60 figure only as the absolute walk-away point, and build in a price-adjustment clause for material and energy costs rather than locking in a price for three years.