Special Order Decisions
Short-term management decisions can be made using either full costing, variable costing, or incremental analysis. Full costing often involves preparing side-by-side income statements and identifying the differences. Incremental analysis is most often the most straight forward, the shortest, the easiest, and the best approach to decision making because it helps managers focus on the relevant parts of a decision. A manager that uses full or variable costing wastes a lot of time capturing and listing costs that will not impact the decision at hand because they do not differ between decisions.
Special order decisions involve determining whether a special order from a customer should be accepted. This type of decision is usually a one-time order that will not impact a company’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 capacity that is sitting idle and not being currently used. The special order decision is based on the difference between the incremental revenue and the incremental costs.
Incremental revenues are the additional revenues generated from accepting the special order that generates additional sales of the product or service. It does not affect current sales as they will remain the same.
Incremental costs are the additional costs incurred from accepting a special order. Variable product costs will always be incremental and cause profits to decline. Other variable costs of operations including selling costs like commissions and shipping costs will be relevant as well. Rarely will cost savings be a consideration in special order decisions.
What Amounts Are Not Relevant in Special Order Decisions?
All costs that will be incurred regardless if a special order decision is accepted or not are not relevant for special order decisions. Most often these will be fixed costs. Occasionally the acceptance of a special order could cause a change in some fixed costs, however this will be an obvious fact when your analyze the information concerning the special order. Sunk costs are not relevant with any special order decision process.
When Should Special Orders Be Accepted?
Special orders should be accepted only if:
Incremental revenue exceeds incremental costs
Present sales are unaffected
The company has idle capacity to handle the order
Special orders which do not meet these criteria should generally not be accepted. Of course, soft-benefits 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 assess the decision.
Flowers Inc. manufactures silk roses. Bud Company has approached Flowers with a proposal to buy 2,000 silk roses for $8,000. Flowers has the necessary capacity. The following costs are associated annually with silk roses when 10,000 units are produced:
Forty percent of the 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.
Step 1: Decide what is not relevant. Allocated fixed overhead is not relevant. The total fixed overhead of $5,400 (60%*$9,000) is the same no matter what decision is made, so it is not part of the analysis.
Step 2: Determine incremental revenue. The amount of $8,000 is given for this problem.
Step 3: Determine incremental costs. The variable material cost must be determined:
$21,000/10,000 = $2.10 per unit
You must then multiply unit cost by the total units in the special order:
$2.10 * 2,000 = $4,200
Because variable costs are increased by $4,200, profit will decrease by $4,200, so the amount is shown as a negative in the incremental analysis.
Step 4: Direct labor is another incremental variable cost. The variable cost per unit is:
$13,000/10,000 units = $1.30 per unit
The labor cost of all 2,000 units = 2,000*$1.30 = $2.600
Because variable costs are increased by $2,600, profit will decrease by $2,600, so this amount is shown as a negative in the incremental analysis.
Step 5: Only the variable portion of the fixed overhead is relevant. First you must determine the variable overhead per unit which is $9,000/10,000, or $0.90 per unit. Of this amount, 40% is variable amounting to $0.36 per unit. The cost of the variable overhead for the 2,000 units in the special order equal 2,000*$0.36 = $720. This is an increased cost which causes profit to decrease so the amount is shown as a negative in the analysis.
The analysis should appear in the following format with respective labels as follows:
Incremental increase in profit if the order is accepted
Because profit increases by $480 if the order is accepted, managers should follow through and accept the order unless qualitative issues warrant otherwise.