Special order decisions involve determining whether or not a special order from a customer should be accepted. From a business perspective, customers often approach a company and ask to buy a specified quantity of product at a specified price. Sometimes the customer will request modifications to the product as well, such as a special logo. This type of decision is usually  a one-time order that will not impact the supplier's regular sales. Before considered a special order, the company must have idle capacity, i.e., it should have the ability to complete the special order without expanding its operations. In other words, it must have resources that can be used to fulfill the order. The special order decision is based on the difference between incremental revenue and the incremental costs.

 


Incremental Analysis Components


Short-term management decisions such as special orders are best performed when based on an incremental analysis. While decisions can be made by examining side-by-side income statements and identifying the differences, incremental analysis is the most straight forward, the shortest, and the easiest approach. Incremental analysis enables managers to focus on the relevant parts of a decision. A manager that prepares side-by-side income statements wastes a lot of time capturing and listing costs that are not relevant as they will not impact the decision at hand.

 

Incremental Revenue

Incremental revenues are the additional revenues generated from accepting the special order. The revenue can result from additional sales of products or from providing services. If the company is operating at less than capacity, revenue of regular customers will not be affected. If the company is operating at capacity, it will have to give up some regular sales in order to provide the special order. 

 

Incremental Costs

Incremental costs are the additional costs incurred from accepting a special order. Variable product costs are always incremental and cause profits to decline. Variable operating costs include selling costs such as commissions and shipping costs are relevant as well. Cost savings do not exist in special order decisions.

 


Amounts That Are Not Relevant in Special Order Decisions


Costs that will be incurred regardless if a special order decision is accepted or not are not relevant for special order decisions. Most often, a company's recurring fixed costs will remain the same in total if a special order is accepted. Occasionally the acceptance of a special order may cause additional fixed costs. In these cases, these additional fixed costs are relevant and should be considered in an incremental analysis. Sunk costs are not relevant with any special order decision process.

 


Evaluating Special Order Decisions


Special order decisions should be generally be accepted if the order is expected to increase profit. Of course, soft-benefits, also known as qualitative issues, should be considered as well.

 

Accept or Reject?

If incremental revenues are less than incremental costs, reject the special order unless qualitative characteristics overwhelmingly impact the decision.

 

If incremental revenues are greater than incremental costs, accept the special order unless qualitative characteristics overwhelmingly impact the decision.

 

If incremental revenues are equal to incremental costs, focus primarily on qualitative characteristics to evaluate the decision.

 


Walk Through Problem


Flowers Inc. manufactures silk roses. Bud Company has approached Flowers with a proposal to buy 2,000 silk roses for $4.00 each. Regular customers are charged $4.25 for each rose. Flowers has the necessary capacity. The following costs are associated annually with silk roses with the company's normal production and sales of 10,000 roses:

 

Direct material

$21,000

Direct labor

13,000

Manufacturing overhead

   9,000

Total

$43,000

 

Forty percent of the manufacturing overhead is variable. All fixed overhead is allocated equally to all products produced. In good form, prepare an incremental analysis to analyze whether Flowers should accept the order from Bud Company.

Solution

Step 1: Determine incremental revenue. The sale of 2,000 roses at $4 each will increase revenue by $8,000 and is relevant.

 

$4.00 x 2,000 = $8,000 

 

The normal sales of 10,000 roses is not incremental as it will produce the same revenue regardless if the special order is accepted or not. 

 

Step 2: Determine incremental variable costs. When 2,000 additional roses are produced, the company will incur material, labor, and variable overhead costs for these roses. Because unit variable costs remain the same regardless of the activity level, you must calculate the variable unit cost for both materials and labor.

Unit direct material cost = $21,000/10,000 roses = $2.10 per rose

Unit direct labor cost = $13,000/10,000 roses = $1.30 per rose

Unit variable overhead cost = [$9,000 x 40%]/10,000 roses = $0.36 per rose

The unit costs of $2.10, $1.30, and $0.36 are for a single rose. Multiple the unit costs by the 2,000 roses in the special order to obtain total incremental variable costs:

Direct materials cost for the special order = $2.10 x 2,000 = $4,200

Direct labor cost for the special order = $1.30 x 2,000 = $2,600

Variable overhead cost for the special order = $0.36 x 2,000 = $720

Because variable costs are increased, profit will decrease by these three incremental amounts. The incremental variable costs are shown as negative amounts in the incremental analysis.

 

Step 3: Determine incremental fixed costs. Allocated fixed overhead is not relevant because the total fixed overhead of $5,400 (60% x $9,000) will result in the same total amount no matter if the order is accepted or not.

 

Step 4: List the amounts in good form beginning with incremental revenue. The analysis should appear similar to the form of an income statement with descriptive line item labels:

 Incremental revenue

$8,000

 Incremental costs:

 

     Direct materials

(4,200)

     Direct labor

(2,600)

     Variable overhead

  (720)

Incremental increase in profit if the order is accepted

$   480

Note the distinctive label adjacent to the $480 net total line of the analysis. It contains three key components:

Because profit is expected to increase by $480 if the order is accepted, managers should follow through and accept the order unless qualitative issues warrant otherwise.

 


This page was last edited on Monday January 05, 2015 02:05 PM
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