You have recently been promoted to Senior Consultant for the professional service firm, BUSI 2083 LLP thanks in part to the hard work in leading the engagement for your client Perfect Stitch. Your firm specializes in providing a wide variety of internal business solutions for different clients. After a weekend of celebrations from your promotion, a Senior Manager calls you into her office first thing Monday morning to help with a technology client who is making a tough decision about closing a plant.
Tiny Bits Digital (TBD) produces high end audio and television equipment. One of the company’s most popular products is a high-definition personal video recorder (PVR) for use with cable and satellite television systems. Demand has increased rapidly for the PVR over the past three years, given the appeal to customers of being able to easily record programs while they watch live television, watch recorded programs while they record a different program, and save dozens of programs for future viewing on the unit’s large internal hard drive.
A complex production process is utilized for the PVR involving both laser and imaging equipment. TBD has a monthly production capacity of 4,000 hours on its laser machine and 1,000 hours on its image machine. However, given the recent increase in demand for the PVR, both machines are currently operating at 90% of capacity every month, based on existing orders from customers. Direct labour costs are $15 and $20 per hour to operate, respectively, the laser and image machines.
The revenue and costs on a per unit basis for the PVR are as follows:
|Cost to manufacture:
|Direct labour—laser process
|Direct labour—image process
|Variable selling costs
On December 1, Daniel Norris, vice-president of Sales and Marketing at ECD, received a special order request from a prospective customer, Fitch Limited, which has offered to buy 250 PVRs at $280 per unit if the product can be delivered by December 31. Fitch Limited is a large retailer with outlets that specialize in audio and video equipment. This special order from Fitch Limited is in addition to orders from existing customers that are utilizing 90% of the production capacity each month. Variable selling costs would not be incurred on this special order. Fitch Limited is not willing to accept anything less than the 250 PVRs requested (i.e., TBD cannot partially fill the order).
Before responding to the customer, Daniel Norris decided to meet with Diane Gadrick, the product manager for the PVR, to discuss whether to accept the offer from Fitch Limited. Excerpts from their conversation follow:
Daniel: “I’m not sure we should accept the offer. This customer is really playing hardball with its terms and conditions.”
Diane: “I know, but it is a reputable company and I suspect this is the way it typically deals with its suppliers. Plus, this could be the beginning of a profitable relationship with Fitch Limited since the company may be interested in some of our other product offerings in the future.”
Daniel: “That may be true, but I’m not sure we should be willing to incur such a large opportunity cost just to get our foot in the door with this client.”
Diane: “Have you calculated the opportunity cost?”
Daniel: “Sure, that was simple. Fitch Limited is offering $280 per unit and we sell to our regular customers at $320 per unit. Therefore, we’re losing $40 per unit, which at 250 units is $10,000 in lost revenue. That’s our opportunity cost and it’s clearly relevant to the decision.”
Diane: “I sort of follow your logic, but I think the fact that we’re not currently operating at full capacity needs to be taken into consideration.”
Daniel: “How so?”
Diane: “Well, your approach to calculating the opportunity cost ignores the fact that we aren’t currently selling all of the PVRs that we could produce. So, in that sense we aren’t really losing $40 per unit on all 250 units required by Fitch Limited.”
Daniel: “I see your point but I’m not clear on how we should calculate the opportunity cost.”
Diane: “This really isn’t my area of expertise either, but it seems appropriate to start by trying to figure out how many of the 250 units required by Fitch Limited we could produce without disrupting our ability to fill existing orders. Then we could determine how many units we would have to forgo selling to existing customers to make up the 250-unit order. That would then be our opportunity cost in terms of the number of physical units involved. Make sense?”
Daniel: “I think so. So, to get the dollar amount of the opportunity cost of accepting the 250-unit order from Fitch Limited we’d then simply multiply the number of units we’d have to forgo selling to existing customers by $40. Correct?”
Diane: “I’m not so sure about the $40. I think we somehow need to factor in the incremental profit we typically earn by selling each PVR to existing customers to really get to the true opportunity cost.”
Daniel: “Now I’m getting really getting confused. Can you work through the numbers and get back to me?”
Diane: “I’ll try.”
Daniel: “Thanks. And by the way, Fitch Limited is calling in an hour and wants our answer.”
Is Diane’s general approach to calculating the opportunity cost in terms of the physical units involved correct? Explain.
Assuming productive capacity cannot be increased for either machine in December, how many PVRs would TBD have to forgo selling to existing customers to fill the special order from Fitch Limited?
Calculate the opportunity cost of accepting the special order.
Calculate the net effect on profits of accepting the special order.
Now assume that TBD is operating at 75% of capacity in December. What is the minimum price TBD should be willing to accept on the special order?
What are some qualitative issues that should be considered when accepting special orders such as that proposed by Fitch Limited?