Faisal Fabrics: special order when the bottleneck is machine hours
Faisal Fabrics runs three products on a single machine which is the binding constraint. Budgeted capacity is 40,000 machine hours a year, of which firm demand from existing customers uses 34,000 hours. An export customer offers to buy 10,000 units of a new variant at Rs 480 per unit. Each unit of the variant needs 1.2 machine hours. Variable cost is Rs 300 per unit. The order requires special tooling costing Rs 400,000 with no alternative use or scrap value. The 6,000 unused hours are genuinely idle - no other work can fill them and no cost is saved by leaving them idle. Product Z, which earns a contribution of Rs 150 per unit and uses 0.5 machine hours per unit, would have to give up hours to make room for the order; Z's demand is firm and lost sales cannot be recovered later.
1. Prepare a relevant-cost analysis of the 10,000-unit offer and recommend acceptance or rejection, including the break-even price per unit.
Read the worked answer
Hours required: 10,000 × 1.2 = 12,000 hours. Only 6,000 are idle, so 6,000 hours must be taken from Z.
Opportunity cost of the displaced hours: Z earns Rs 150 per 0.5 hour = Rs 300 per machine hour. 6,000 hours × Rs 300 = Rs 1,800,000 of contribution forgone.
| Item | Rs |
|---|---|
| Incremental revenue (10,000 × 480) | 4,800,000 |
| Variable cost (10,000 × 300) | (3,000,000) |
| Special tooling (incremental, no alternative use) | (400,000) |
| Opportunity cost of 6,000 Z hours | (1,800,000) |
| Net relevant effect | (400,000) |
Recommendation: reject. The order destroys Rs 400,000 of profit. The idle hours are free, but the displaced hours are the most expensive input in the order.
Break-even price: total relevant cost Rs 5,200,000 ÷ 10,000 units = Rs 520 per unit, about 8% above the offered Rs 480. A price of Rs 520 would leave the company no better off; anything below it reduces profit.
Common trap to avoid: comparing Rs 480 with the absorption cost of the variant (which includes an arbitrary share of fixed overhead) or with variable cost of Rs 300. Neither reflects the constraint.
2. The customer now says it will take only 5,000 units at Rs 480, with the same tooling requirement. Advise, and identify the risks in accepting.
Read the worked answer
Hours required: 5,000 × 1.2 = 6,000 hours - exactly the idle capacity, so no Z contribution is displaced.
| Item | Rs |
|---|---|
| Revenue (5,000 × 480) | 2,400,000 |
| Variable cost (5,000 × 300) | (1,500,000) |
| Special tooling | (400,000) |
| Opportunity cost | nil |
| Net relevant benefit | 500,000 |
Advice: accept on the numbers - Rs 500,000 of incremental profit, because the tooling is recovered without sacrificing Z. The tooling is a one-off cost of Rs 80 per unit at this volume; it is irrelevant to a decision made after it is sunk, but fully relevant now, so it must not be ignored when pricing.
Risks
- Precedent. Rs 480 is below the 10,000-unit break-even of Rs 520. The customer may return for the full 10,000 units and cite the established price; the company must be able to say no next year.
- Capacity creep. If firm demand from existing customers rises, the 'idle' hours disappear and the order becomes loss-making; build a cancellation or volume-flexibility clause.
- Tooling life. If the tooling also serves future standard production, treat part of it as a capital investment rather than an order cost, and check the cost is incremental at all.
- Learning and quality. An off-spec or late first export batch damages future export pricing far more than Rs 500,000.
- Currency and credit. Export receipts may carry credit and exchange risk not captured in the analysis.