Chapter 6

Dealing with Excess Supply

and Excess Demand in the
Short Term
 Why do we care?
• We always have either too little demand or too much
demand => need to figure out what to do in these
situations

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 Supply and Demand in the Short Term
• In the short term, we cannot adjust capacity resources
(buildings, equipment, skilled staff)
=> capacity is fixed and non-controllable
 In the long term, we choose capacity based on expected
future demand over many years
* capacity = maximum activity level that can be sustained with the available
capacity resources

• Demand changes frequently => temporary gaps

between demand and supply of capacity
 excess demand: demand > supply
 excess supply/excess capacity: demand < supply

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 Temporary gaps between Demand and Supply

excess
demand

(supply)
excess supply
(excess capacity)

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 Dealing with
Excess Supply
You have unused capacity. Find some profitable use for this capacity.

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 Example: Special Order
• You own a restaurant. Capacity is 100 dinners a day. The regular
price is $30 per dinner. Variable costs are $10 per dinner. Fixed
costs are $500 per day.
• On Mondays, business is slow. You expect to sell only 40 dinners
(i.e., a lot of unused capacity)
• Special order: A charity wants to hold its fundraising dinner in
your restaurant on Monday. They offer to pay $15 per dinner for a
total of 50 dinners.
• Should you take this special order?

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 Special Order – Gross Approach
Gross approach: compute revenue, costs, and profits by brute force for
each scenario

status quo special order

(40 regular dinners) (40 regular dinners
+ 50 special-order dinners)
Revenue $1,200 $1,950
($30 per regular dinner,
$15 per special-order dinner) (=40*$30) (=40*$30+50*$15)
Variable costs $400 $900
($10 per dinner)
(=40*$10) (=40*$10+50*$10)
Contribution margin $800 $1,050
Fixed costs $500 $500
Profit $300 $550
Profit is higher if you take the special order => you should take it

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 Special Order – Incremental Approach
Another approach: compute incremental revenue, incremental
costs, and incremental profit relative to the status quo.
• i.e., how do revenue, costs, and profit change relative to the status quo?

Incremental revenue
($15 per special-order dinner)
Incremental variable costs
($10 per dinner)
special order
(+ 50 special-order dinners)
$750 (=50*$15) you sell 40 regular
dinners in both cases, so
the incremental revenue
$500 (=50*$10) and costs of regular
dinners are zero

Incremental contribution $250

margin
Incremental fixed costs $0 FC=$500 in both cases,

Incremental profit $250 so incremental FC=0

Incremental profit is positive => take the special order

* Incremental and gross approaches are equivalent – use whichever is more convenient

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 Exercise: Special Order
Generic Motors (GM) makes cars. The regular price is $10,000 per car.
A car rental company wants to buy 10 cars at a discounted price of
$8,000. This is a one-time deal (i.e., a short-term decision), and GM
has enough spare capacity.
Should GM take this special order?
cost Use the incremental approach:
per car
direct materials $3,000 Incremental revenue =
direct labor $1,000
Incremental VC =
var. overhead $2,000
fixed overhead $3,500
Incremental CM =
unit cost $9,500
Incremental FC =

Incremental profit =

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Exercise: Reduce the price or increase advertising?
Sales are low because of a recession. You have two options to stimulate sales:
(A) Reduce the price by 20%. This will increase sales volume by 25%.
(B) Buy additional advertising for $600. This will increase sales volume by 30%
at the original price.
What should you do?
Use the gross approach
status quo (A) reduce price (B) increase advertising

Sales volume 100

Revenue $5,000

VC $2,000

CM $3,000

FC $4,000

Profit (loss) ($1,000)

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 Make vs Buy Decisions
• make components in-house or buy them from outside suppliers
(outsource)
• who makes the components in the iPhone?
 screen: Samsung
 processor: TSMC
 GPS: Broadcom
 memory: Samsung, Intel

• many firms outsource the production of their finished products

 who manufactures the iPhone?
 Apple  Foxconn  Samsung

• we assume that Make vs Buy decisions do not affect sales

=> choose “make” or “buy” based on costs
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 Exercise: Make vs Buy
Generic Motors makes engines for its cars in-house. It needs 100 engines per
month. An outside supplier has offered to supply equivalent engines at a
wholesale price of $2,500 per unit.
Should GM outsource the production of engines? How will this decision
affect GM’s profit? (treat this as a short-term decision and assume that GM
has sufficient capacity to make the engines in-house)
GM’s production costs MAKE BUY
cost per
engine unit VC

direct materials $1,000

total VC
direct labor $500
var. overhead $500 same FC in both cases (a short-term decision)
fixed overhead $1,000 If you outsource (“buy”), then
total $3,000 incr. revenue =
incr. VC =
incr. CM =
incr. FC =
12 incr. profit =
 Dealing with
Excess Demand
You have more demand than capacity.
Try to squeeze higher profit from each unit of capacity.

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 Dealing with excess demand:
 increase prices
 btw: When Apple introduces a new iPhone, they often face
massive excess demand in the first few weeks. Why don’t
they temporarily increase the price to take advantage of the
excess demand? (e.g., charge $2,000 for an iPhone in the
first two weeks and then reduce the price)
 outsource part of production
 change the product mix to focus on the most
profitable products

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 Best Use of Scarce Capacity:
Choosing the Product Mix
• You make several products
• You face excess demand (i.e., not enough capacity to fully
meet the demand)

• To maximize profit when capacity is in short supply,

maximize CM per unit of capacity
 Make product(s) with the highest CM per unit of capacity,
ignore products with low CM per unit of capacity

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 Exercise: Choosing the Product Mix
You make products A, B, and C. You have limited capacity of 200 machine
hours. The demand for all three products is booming (assume unlimited
demand for simplicity). You do not have sufficient capacity to fully meet the
demand for any of the products. Which product should you make?

A B C
Price $10 $50 $200
Unit variable cost $3 $20 $100
Machine-hours per unit 0.1 hrs 0.25 hrs 1 hrs

CM per unit of capacity

(per machine-hour)

Should make:
 A only
 B only
 C only
 all three products to take advantage of the high demand
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 Additional Exercises

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 Exercise: Special Order
Giant Motors (GM) Company sells big SUVs at a regular price of $50,000. The
FBI wants to buy 10 black SUVs at a discounted price of $35,000. This is a
one-time deal (i.e., a short-term decision), and GM has enough spare capacity
to fulfill this special order.
Should GM take this special order?
 gross approach?
cost per
 incremental approach?
unit
direct materials $15,000
direct labor $5,000 Incremental revenue =
var. overhead $10,000
Incremental VC =
fixed overhead $17,500
total $47,500 Incremental CM =

Incremental FC =

Incremental profit =

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 Exercise: Price reduction
Sales are low because of a recession. If you reduce the price by 20%, sales
volume in units will increase by 40%. Should you reduce the price?
 gross approach?
 incremental approach?
status quo Reduced price scenario

Sales volume 100

Revenue $10,000

Variable costs $4,000

Contribution margin $6,000

Fixed costs $3,000

Profit (loss) $3,000

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 Exercise: Make vs Buy
Bell Computer produces its laptops in-house. An outside supplier has offered
to supply identical laptops to Bell at a wholesale price of $360 per unit. Bell
needs 1 million laptops per month.
Should Bell make or buy? How will this decision affect Bell’s profit?
(treat this as a short-term decision and assume that Bell has sufficient
capacity to make the laptops in-house)
MAKE BUY
cost per
unit unit VC
direct materials $300
direct labor $20 total VC
var. overhead $30 same FC in both cases (a short-term decision)
fixed overhead $100 If you outsource (“buy”), then
total $450 incr. revenue =
incr. VC =
incr. CM =
incr. FC =
20
incr. profit =
 Exercise: Choosing the product mix
You make 3 products. You have limited capacity of 500 machine-hours. You
face excess demand for all three products (assume unlimited demand for
simplicity). Which product(s) should you make?

Basic Premium Supreme

Price $100 $500 $2,000
Unit variable cost $30 $200 $1,000
Machine hours per unit 1 hr 2 hrs 10 hrs

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 Exercise: Dealing with excess demand
and excess supply
Which of the following are reasonable ways to deal with
excess demand and excess supply?

Excess demand Excess supply

increase prices  YES  NO ignore
reduce prices  YES  NO  YES  NO
find additional special orders at a  YES  NO  YES  NO
discounted price
increase advertising  YES  NO  YES  NO
reduce advertising  YES  NO ignore
use all available capacity to make the  YES  NO  YES  NO
product with the highest CM per unit
of capacity

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