Himalayan Snacks: The Dharan Wholesale Offer
Himalayan Snacks, a Birgunj manufacturer of instant noodles, runs one plant with a rated capacity of 60,000 packets a month and currently produces and sells 48,000. The cost sheet at current volume shows: selling price Rs 40 per packet; direct material Rs 14; direct labour Rs 6; variable overhead Rs 3; fixed overhead Rs 8 (Rs 3,84,000 a month); variable selling and distribution Rs 2. Full cost is therefore Rs 33 and the reported margin Rs 7 per packet.
A wholesaler in Dharan offers a six-month contract for 12,000 packets a month at Rs 30 per packet, delivered to his warehouse. The order needs a sturdier outer carton, adding Rs 1.50 per packet, and the wholesaler will not accept part shipments. Sales staff earn a 2 percent commission on revenue from all sales, and the two field officers have begun pressing hard for the order because it is easy volume. The plant manager says 60,000 packets is achievable only with scheduled overtime, and the production supervisor warns that any breakdown would hit domestic supplies first.
1. Should the firm accept the Rs 30 order on financial grounds? Show the relevant-cost working and state the conditions attached to acceptance.
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Relevant-cost working (per packet)
| Item | Rs | Relevant? |
|---|---|---|
| Price, Dharan order | 30.00 | - |
| Direct material | 14.00 | yes |
| Direct labour | 6.00 | yes |
| Variable overhead | 3.00 | yes |
| Variable selling and distribution | 2.00 | yes (may be avoidable) |
| Extra carton | 1.50 | yes |
| Total relevant cost | 26.50 | |
| Contribution | 3.50 | |
| Fixed overhead | 8.00 | no - unchanged by the order |
The full-cost comparison is the trap. Rs 30 looks below the Rs 33 full cost, but Rs 8 of that is an absorption of fixed overhead already committed at 48,000 packets; it does not increase if the order is taken. The correct test is contribution against relevant cost.
12,000 x Rs 3.50 = Rs 42,000 a month, Rs 2,52,000 over six months, assuming the order uses genuinely idle capacity.
Conditions: (a) no Rs 40 domestic sale is displaced - at 60,000 the plant is at full capacity and domestic customers must not be turned away; (b) any overtime premium is charged to this order - at a Rs 1.00 premium contribution falls to Rs 30,000 a month, at Rs 1.50 to Rs 24,000; (c) the six-month commitment is enforceable in writing, because cartons and overtime are committed costs; (d) the wholesaler does not resell into the firm's existing domestic territory at Rs 40.
2. Analyse whether the 2 percent revenue commission explains the field officers' behaviour, and design a commission structure aligned with contribution.
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The incentive explains the behaviour - the arithmetic is not subtle.
On the Dharan order, 2 percent of Rs 30 is Rs 0.60 per packet, or Rs 7,200 a month for 12,000 packets. On a Rs 40 domestic packet it is Rs 0.80. So per packet the order pays less, which superficially looks correct. But per rupee of value created it pays far more: Rs 7,200 commission against Rs 42,000 of contribution is 17.1 percent of contribution, whereas a domestic packet pays Rs 0.80 against Rs 15 of contribution, or 5.3 percent. The scheme rewards the low-margin order roughly three times as generously per unit of value, so the officers are behaving rationally inside a badly designed plan.
Redesign. Convert to a commission on contribution. To leave domestic pay unchanged, set the rate at 0.80 / 15 = 5.33 percent of contribution: a domestic packet still pays Rs 0.80, while the Dharan packet pays 5.33% x 3.50 = about Rs 0.19, or Rs 2,240 a month for the whole order. That collapse is the honest signal - the order creates very little value and should not be sold as though it creates a lot.
If the firm wants volume in a slack season, pay a separately budgeted, capped seasonal volume incentive that the plant manager must countersign, so the person authorising overtime is not the person earning the bonus from it.
3. A Dharan retailer offers Rs 31 per packet for 12,000 a month but demands exclusivity, which would replace 3,000 packets a month now sold at Rs 40 through the existing dealer. Compare this with the Rs 30 order and recommend.
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Rs 30 order, no displacement: 12,000 x Rs 3.50 = Rs 42,000 a month of incremental contribution.
Rs 31 order with exclusivity. Same Rs 1.50 carton, so variable cost stays Rs 26.50 and contribution is Rs 4.50 per packet. Total contribution on 12,000 packets = Rs 54,000. But exclusivity removes the existing dealer's 3,000 packets at Rs 40, whose contribution is 40 - 25 = Rs 15 each, so Rs 45,000 of contribution disappears. Net = 54,000 - 45,000 = Rs 9,000 a month, roughly a fifth of the Rs 30 alternative.
Why the higher price loses. Price per packet is the wrong unit of analysis; contribution per packet of capacity is the right one. The Rs 31 deal earns Rs 4.50 on packets that would have been made anyway and destroys Rs 15 on packets it replaces.
Sensitivity and strategy. The exclusivity deal uses only 57,000 packets, so no overtime is needed; if the overtime premium on the Rs 30 order is Rs 1.00 per packet (Rs 12,000), the Rs 30 order nets Rs 30,000 against Rs 9,000 and still wins. Exclusivity also hands the Dharan market to one party for six months and forfeits the dealer relationship.
Recommendation: take the Rs 30 order subject to the capacity and overtime conditions; decline the exclusivity offer, or counter at about Rs 33 without exclusivity.