Question

Hinds Industries, Inc. is a manufacturer of soup and condiment products under its own standard and premium labels. The company has been in business for many years and is a “household name”. Its Denver soup plant has a capacity of 120,000 cases/mo, but has been operating at a normal volume of 85,000 cases/mo. Hinds has been approached by Mondo Mart, a large discount retailer, about producing a line of soups under a Mondo Mart house label. Mondo would initially place an order for 15,000 cases/mo, with the understanding that the order will be expanded if the product is successful. The initial order would be for a reduced line of four relatively simple soups, following Hinds’ normal recipes. All of these soups have essentially the same production cost of $31 per case, as follows: ingredients and packaging, $17; direct labor, $3; overhead, $11. The overhead is 55% fixed manufacturing costs, 25% variable manufacturing costs, and 20% allocated general corporate overhead. Hinds would incur $6,000/mo additional setup costs if the order is accepted. Packaging would cost twenty cents/case less because of a cheaper label used by Mondo. Hinds normally sells these soups for $38/case. Mondo Mart has offered $29/case, arguing that the steep discount is necessary for them to price the product in conformity with their pricing philosophy and customer expectations. The regional marketing director is inclined to reject the offer, because it is below cost, and therefore Hinds will lose money on the contract. The ultimate decision is up to the regional director of operations.

Required: Discuss the factors that the operations director should consider in making the decision.

Answer 1

The key factor to consider, given the facts of this case would be capacity utilisation of the factory. Currently, out of a total capacity of 120,000 pieces, the unit is operating at a capacity of 85,000 units. Considering that the unit is operating at lower capacity, the key factor to consider in this case from a decision making perspective would be incremental costs. These would be he variable costs that are incurred for making soaps. The fixed manufacturing overheads will not increase due to incremental manufacturing of soaps. In the given case, the decision can be made based on the following data points:

Particulars	Amount
Sale price per unit	29
Ingredients and packaging	17
Direct labour	03
Variable manufacturing overhead (25% of 11)	2.75
Saving in packing cost	(0.20)
Total variable cost	22.55
Net contribution per unit (29-22.55)	6.45
Order size	15,000
Total contribution (15000*6.45)	96,750
Incremental set up costs	(6,000)
Net increase in contribution	90,750

           

Based on the above calculation, the order should be accepted as it provides an incremental income of USD 90,750, the key premise being, due o under utilisation of capacity, fixed costs, which in effect are sunk costs, should not be considered for decision making purpose. Instead, the only the variable and any other incremental costs should form the basis of this decision.