Special Order at Al-Noor Textiles
Al-Noor Textiles produces 7,600 school shirts a month and has a capacity of 8,000. The normal selling price is 1,200 per shirt, variable cost is 700, and monthly fixed costs are 1,500,000. A local school offers a one-time order for 1,000 shirts at 850 each, provided the shirts carry the school's logo. The logo requires a one-time setup costing 60,000. The order would use 1,000 units of capacity, but the firm already sells 7,600 shirts a month at the normal price, so accepting it means displacing 600 normal shirts. The sales manager argues that fixed costs are already covered and that any price above the 700 variable cost is profitable. The production manager warns that the logo setup may delay normal orders and that the school sits in the same city as two existing customers who pay the full price and expect confidentiality. The managing director wants a recommendation with numbers and a clear statement of assumptions.
1. Compute the incremental effect of accepting the order. On financial grounds alone, should Al-Noor accept? Show the relevant costs.
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Incremental analysis
- Extra revenue from the order: 1,000 × 850 = 850,000
- Extra variable cost: 1,000 × 700 = 700,000
- Contribution from the order before displacement: 850,000 − 700,000 = 150,000
- Displaced normal sales: 1,000 ordered units − 400 spare capacity units = 600 units
- Lost contribution on displaced units: 600 × (1,200 − 700) = 600 × 500 = 300,000
- One-time logo setup: 60,000
- Net incremental effect: 150,000 − 300,000 − 60,000 = −210,000
Fixed costs of 1,500,000 are not relevant to this decision because they do not change with the order. The existing fixed-cost recovery is a sunk allocation, not an incremental cost.
Recommendation: reject the order on financial grounds alone. Accepting reduces monthly profit by 210,000. The minimum acceptable price per shirt, holding the displacement and setup assumptions, is 700 variable cost + 300 opportunity cost per unit + 60 setup per unit = 1,060, which is far above 850.
2. Evaluate the sales manager's claim: 'Any price above variable cost 700 is profitable because fixed costs are already covered.' Under what condition is the claim true, and why is it false here?
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The claim is true only under a narrow condition: the firm has idle capacity that cannot otherwise be used, the order does not displace any normal sale, and it does not cause price erosion or other changes in normal demand. In that case, any price above the incremental variable cost adds contribution toward fixed costs and profit.
The condition fails here. Al-Noor has only 400 units of spare capacity, so a 1,000-unit order displaces 600 normal shirts. Each displaced shirt loses 500 of contribution. That lost contribution is an opportunity cost of accepting the order, and it must be added to the 700 variable cost. The relevant unit benchmark is therefore not 700 but approximately 1,060 once the 300 per-unit opportunity cost and 60 per-unit setup are included.
A useful check is to compare total contribution, not unit price with unit variable cost. The order adds 150,000 of contribution but destroys 300,000 of normal contribution and consumes 60,000 of setup, so it is value-destroying. The sales manager is treating a scarce-capacity decision as if capacity were free.
3. Identify two qualitative factors that could change the decision and explain how you would test each one.
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1. Price erosion among existing customers. The school is in the same city as two existing customers paying 1,200. If they learn of the 850 price, they may demand concessions or shift orders. Test: estimate the probability and size of a concession demand, then compute the future contribution loss. For example, if the two customers represent 1,200 shirts a month and obtain a 100 per-shirt discount, the loss is 120,000 a month-far more than the 210,000 one-off loss already calculated, and enough to make rejection even clearer. Confidentiality clauses and separate branding can reduce but not eliminate this risk.
2. Operational disruption and reputation. The logo setup may delay normal orders, damaging service levels. Test: ask production for the changeover time and the probability of missed normal deadlines; estimate penalty payments, expediting costs or lost future orders. A small delay cost would not reverse the financial rejection, but a large contract with a major customer could.
A third factor is strategic: the school order could open a new institutional segment. Test it by estimating repeat orders at a sustainable price, not by counting the one-time order. If repeat business at 1,060 or above is likely, the strategic case could justify accepting a loss-leader order; otherwise the financial rejection stands.