Short-Term Decision Making- Special Order (Part 3)

Sometimes, when a company has spare production capacity, it is willing to fulfill SPECIAL ORDERS for non-regular customers. Normally, the prices quoted are lower than those regular customers.

So When do a Company Accept or Reject a Special Order?

Generally, the rule is to accept the order as long as the incremental revenue is MORE than the incremental costs since this will result in incremental profit

Incremental Revenue =Special Order units x Special Order price

Incremental Costs= Variable costs +extra fixed overheads + opportunity costs that relates to the production of that special order

Incremental Profit =Incremental Revenue-Incremental Cost

Illustration:

Say Company A has capacity to produce 100,000 units of product X. The cost estimate per unit based on current capacity of 80% is as follows:

$ per unit

Direct material                                $2.00

Direct labor                                     $5.00

Variable production overhead            $3.00

Fixed production overhead                $4.00

Total                                            $14.00

The company sells the product X to its regular customer at $20.00. However, a non- regular customer has approached the company to purchase the excess capacity at $18 each.

Question: Should Company A accept this special order?

Solution:

If the special order is accepted:

Incremental revenue ( 20% x 100,000 x $18) $360,000

Less:

Incremental cost

Direct material ($2.00 x 20,000) $40,000

Direct labor ($5.00 x 20,000) $100,000

Variable production o/h ($3.00 x20,000)  $60,000

Total incremental cost             $200,000

Incremental profit                     $160,000

(PS: the above takes only the relevant costs hence ignoring fixed production overheads as it is still below 100% production capacity)

·In the above case, we have assumed that there is spare capacity but it’s important to ensure that there is really sufficient capacity before agreeing on special order;

·ask whether there is any better alternative than accepting special order;

·by accepting special order, needs to ensure that this special order does not affect customer loyalty or affecting the status quo of the existing product, in the above case is product X. Basically, we should not endanger the existing products by wanting to utilize full production capacity.