Which of the following is a decision that focuses on whether a specially priced order should be accepted or rejected?

One type of short-term decision that businesses frequently have to make is whether or not to accept special order requests from customers. A special order is an order that the company did not anticipate when developing its budget for the year. Therefore, this is an additional opportunity to generate revenue above sales goals. Special orders typically request a lower price than normally offered and/or might include additional costs. Often students get caught up in the lower price or lower contribution margin and want to disregard the order immediately. However, if the order will bring in additional profit, the order should be considered.

When faced with a special order decision, a company should consider the following three items:

1. Does the company have the excess capacity to fulfill this order?

Remember that a special order is an order that the company did not expect. The company must make sure that there is excess capacity to fill this order without harming the original plan developed for the year.

2. Will the order be profitable?

Typically, a special order will have a reduced price and/or additional costs. Will the price be high enough to cover the incremental costs associated with the order. Think back to overhead allocation. When overhead allocation rates were developed at the beginning of the year, they were based on the planned production. These special orders are in addition to the planned production. Therefore, fixed overhead would not be applied to these jobs. This allows the company to make the products needed for the special order at a reduced cost. Although the price might be lower, the company may be able to achieve profit on the job.

3. Will the order affect planned sales, now or in the future?

The company must insure that the special order will not hurt other sales. It is important to make sure that the customer requesting the special order does not compete with existing customers or the company itself, which would result in decreased sales at regular prices. Special orders can also lead to unhappy existing customers if they find out about the special deal you gave someone else. Careful consideration must be made when accepting special orders to protect current and future profits.

Identify the relevant costs

In order to identify the relevant costs associated with a special order decision, we must look at the existing costs to determine which costs will be paid if the order is accepted. Previously incurred fixed costs are never relevant. The only fixed costs that should be considered are fixed costs that are incurred because of the special order. Then consider your variable costs. Are there any variable costs that will not be paid with this special order? Sometimes variable selling costs are excluded from the calculation because no sales commission will be paid on the order. These savings can help decrease the cost and increase the profitability of the job.

Carefully read the problem to ensure you have identified the relevant and irrelevant costs properly.

Should the company accept the job?

Typically in problems you will do in class, you will only consider the quantitative factors. Use the contribution margin approach to calculate if the job will generate profit or loss:

1. Calculate the contribution margin per unit

Calculate the contribution margin (price – variable costs) per unit for the special order. Exclude irrelevant costs from the calculation.

2. Calculate the total contribution margin

Multiply the number of units in the special order by the contribution margin per unit.

3. Subtract any incremental fixed costs from the contribution margin to determine profit or loss

If there are any incremental fixed costs, subtract those costs from the contribution margin. If there are no incremental fixed costs, the contribution margin is all profit.

4. Determine if you should accept the job

If there are no extenuating qualitative issues, accept the job if it will generate additional profit. If there is a loss on the job, do not accept the job.

Final Thoughts

These problems are not difficult. The hardest part is to identify the irrelevant costs and remove them from your calculations. Use what you have learned about contribution margin to determine if you have profit on the special order.

Related Video

Special Order Decision Making

Question: We have already learned that managers use differential analysis for make-or-buy decisions, product line decisions, and customer decisions. Differential analysis also provides a format that helps managers decide whether to accept special orders made by customers. What is a special order, and how can differential analysis be used to make a special order decision?

Answer: A special orderA unique one-time order made by a customer. is a unique one-time order made by a customer. Differential analysis provides a format that helps managers decide whether to accept or reject special orders, as shown in the example that follows.

Special Order Considerations

Assume Tony’s T-shirts makes shirts for local soccer, baseball, basketball, and other sports teams. The owner, Tony, purchases the shirts and prints graphics on the shirts for each team. The graphics were designed several years ago, so design costs are no longer incurred. On average, Tony sells 1,000 shirts each month. Typical monthly financial data follow:

The monthly information provided relates to the company’s routine monthly operations. A representative of the local high school recently approached Tony to ask about a one-time special order. The high school will be hosting a statewide track and field event and is willing to pay Tony’s T-shirts $17 per shirt to make 200 custom T-shirts for the event. Because enough idle capacity exists to handle this order, it will not affect other sales. That is, Tony has the factory space and machinery available to produce more T-shirts.

Tony incurs the same variable costs of $13 per unit to produce the special order, and he will pay a firm $600 to design the graphics that will be printed on the shirts. This special order will have no other effect on Tony’s monthly fixed costs.

Question: Should Tony accept the special order?

Answer: Let’s use differential analysis to answer this question. As shown in Figure 7.13 "Special Order Differential Analysis for Tony’s T-Shirts", Alternative 1 assumes Tony rejects the special order, and Alternative 2 assumes he accepts the special order. The differential analysis in Figure 7.13 "Special Order Differential Analysis for Tony’s T-Shirts" shows that Tony’s would be better off accepting the special order, as profit increases $200.

Figure 7.13 Special Order Differential Analysis for Tony’s T-Shirts

a $23,400 = $20,000 + ($17 per shirt × 200 shirts).

b $15,600 = $13,000 + ($13 × 200 shirts).

c $4,600 = $4,000 + $600 cost for special order design.

Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts" provides an alternative presentation of differential analysis for Tony’s T-shirts. As discussed earlier in the chapter, this presentation summarizes the differential revenues and costs.

Figure 7.14 Summary of Differential Analysis for Tony’s T-Shirts

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.

Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts" shows the differential revenues and costs for the special order being considered. If Tony’s T-shirts accepts the special order, sales revenue will increase $3,400 with a corresponding increase in variable costs of $2,600. Fixed costs will increase by $600 because design work is required for the special order. Thus profit will increase by $200 (= $3,400 − $2,600 − $600).

Special Order Assumptions

Question: What assumptions were made with the differential analysis performed for Tony’s T-shirts?

Answer: We made two important assumptions in the Tony’s T-shirts special order example. The first assumption is that Tony’s has enough idle capacity to handle the order without disrupting regular customer orders. Suppose Tony’s T-shirts is operating at capacity and cannot produce any more T-shirts. Tony must turn away regular customers to make room for the special order. In this scenario, the opportunity cost of turning away existing customers must be considered in the differential analysis.

The second assumption is that this is a one-time order, and therefore represents a short-run pricing decision. If Tony’s T-shirts expects future orders from the high school at the $17 per shirt price, the company must consider the impact this might have on long-run pricing with other customers. That is, regular customers may hear of this special price and demand the same price, particularly those customers who have been loyal to Tony’s T-shirts for many years. Tony’s might be forced to lower prices for regular customers, thereby eroding the company’s profits over time. The key point is that companies evaluating special orders can drop prices in the short run to cover differential variable and fixed costs. But in the long run, prices must cover all variable and fixed costs.

Computer Application

Using Excel to Perform Differential Analysis

Managers often perform differential analysis with the help of computer software for several reasons:

• Once the format is established, the template can be used repeatedly for different scenarios.
• Formulas underlie all calculations, thereby minimizing the potential for math errors and speeding up the process.
• Changes can be made easily without having to redo the entire analysis.

An example of how to use Excel to perform differential analysis for the special order scenario presented in Figure 7.13 "Special Order Differential Analysis for Tony’s T-Shirts" is shown here. Although many accounting courses do not require the use of computer spreadsheets, you are encouraged to use spreadsheet software like Excel when preparing homework or working review problems.

Key Takeaway

• Managers often use differential analysis to decide whether to accept a special one-time order made by a customer. Managers compare sales revenue and costs for each alternative (accept or reject the special order), and select the alternative with the highest profit. Organizations must be careful to consider the long-run implications of reducing prices for special orders.

Review Problem 7.6

The following monthly financial data are for Quicko’s, a company that makes photocopies for its customers. On average, Quicko’s makes 100,000 copies each month.

Quicko’s is approached by a local restaurant that would like to have 20,000 flyers copied. The restaurant asks Quicko’s to produce the flyers for 7 cents a copy rather than the standard price of 8 cents. Quicko’s can produce up to 130,000 copies a month, so the special order will not affect regular customer sales. Variable costs per copy will remain at 5 cents, but production of the restaurant flyers will require a special copy machine part that costs $250. This special order will have no other effect on monthly fixed costs.

1. Using the differential analysis format presented in Figure 7.13 "Special Order Differential Analysis for Tony’s T-Shirts", determine whether Quicko’s would be better off accepting or rejecting the special order.
2. Summarize the result of accepting the special order using the format presented in Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts".
3. Assume Quicko’s can only produce 100,000 copies per month, and that regular customer sales would decrease as a result of the special order. Using the differential analysis format presented in Figure 7.13 "Special Order Differential Analysis for Tony’s T-Shirts", determine whether Quicko’s would be better off accepting or rejecting the special order.

Solution to Review Problem 7.6

1. 

   a $9,400 = $8,000 + ($0.07 per copy × 20,000 copies);or alternative approach: ($0.08 per copy × 100,000 copies) + ($0.07 per copy × 20,000 copies).

   b $6,000 = $5,000 + ($0.05 per copy × 20,000 copies); or alternative approach: $0.05 × 120,000 copies.

   c $2,250 = $2,000 + $250 cost for copy machine part.

   This analysis shows that Quicko’s would be better off accepting the special order because profit is $150 higher for Alternative 2.

2. 

   Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.

3. Assuming Quicko’s has a capacity of 100,000 copies per month, the analysis shows the company would be better off rejecting the special order because profit is $450 higher for this alternative.

   

   a $7,800 = ($0.08 × 80,000 regular customer copies) + ($0.07 × 20,000 special order copies).

   b $2,250 = $2,000 + $250 cost for copy machine part.

Which of the following costs is irrelevant to a decision to accept or reject an order?

Which of the following will help an organization decide whether to keep or drop a product line?

What is the term for the act of choosing among alternatives with an immediate or limited end in view?

What should be true in order for costs or benefits to be relevant?