Question

JTM Ltd incurs costs of $16 per unit ($12 variable, $4 fixed) for a widget it sells for $22. JTM has received two special offers: Firm A wants 10,000 units and Firm B wants 14,000 units. Both firms will sell the widgets for $17, and JTM has capacity to produce 12,000 additional units. From a cost perspective, what is the main difference between these two offers?

Answer 1

Answer:

We must analyze the potential benefits of choosing one order or the other one:

Current JTM costs:

• $12 variable per unit
• $4 fixed per unit

If JTM accepts Firm A's order its fixed costs will not vary and it will be able to increase its profits by: ($17 - $12) x 10,000 = $50,000

Since JTM doesn't have the capacity to fulfill Firm B's order with their current cost structure, if it decides to take it, its variable or fixed costs (we don't know which) will probably increase, so its contribution margin will no longer be $5, as with Firm A's order, but will probably be lower. We are not told by how much the costs would increase.

The third alternative is to accept Firm B's offer and not sell 2,000 units through its normal distribution channels, but that would result in an increase in profits but also loss of normal profits:

($5 x 14,000 units) - ($6 x 2,000 units for the lost normal profits) = $70,000 -  $12,000 = $58,000. If JTM is able to cancel the sale of 2,000 units, then Firm B's offer would increase its profits by $58,000, $8,000 more than Firm A's order, but it depends on its ability to cancel or not the normal sales.