Special Order Decisions

This is when businesses need to decide if to accept orders that are on special terms

Prices lower than normal – if the contribution is positive generally accept the order

However have to consider:

• If more Fixed Costs result from the order
• May the order increase the level of Variable Costs
• If the company will resell the product
• If it may lead to future sales – if this is the case may accept an order that doesn’t make a positive contribution

Prices would be higher than normal

Normally customers would accept this

However if specifications have to be altered it may prove to be expensive for the business

The firm would need to:

• Calculate any extra variable costs associated with the order
• Assess if sufficient capacity to meet order
• Decide if it increases contribution and profits

Here is an adapted A Level question where marginal costing and product contribution can be used to make a decision.

A single-product manufacturer has this cost structure: materials £25, direct labour £28, and variable overheads £12 per unit; fixed overheads total £420 000. Its product price is £120, annual output (80% of capacity) being 20000. A DIY store has enquired whether it can buy an extra 4000 units per annum, to sell as ‘own label’ items. It will pay £85 for each unit. The manufacturer will have to incur £10 000 set-up costs. Is the offer worth accepting?

The present contribution is £55 per product: selling price £120 less £65 variable costs (i.e. £25 + £28 + £12). Break-even point is £420 000/£55 = 7636 sales, the margin of safety is 12364 (20 000 – 7636) and the forecast profit is £680 000 (12 364 × £55). Note how these calculations can be checked:

• break-even revenue £120 × 7636 = £916 320
• break-even costs total the same, i.e. £420 000 + £496 340 (7636 × £65) (the £20 difference is due to rounding)
• profit at 20 000 output = revenue £2 400 000 (£120 × 20 000) less cost £1 720 000 (£420 000 fixed + £1300 000 variable, i.e. 20 000 × £65) = £680 000

The key question is: should the new order be taken on? Numerically, the calculations for this order show:

• unit contribution £20 (£85 – £65)
• total contribution £80 000 (4000 × £20)
• total profit £70 000 (£80 000 – £10 000 set-up costs).

The main marginal costing principle here is that, because all fixed costs are already covered (by the normal production and sales exceeding the break-even point), the contribution made by this special order is all profit.

Non-financial factors are also important in making such decisions. For example:

• is the special order the most profitable way of utilising spare capacity, or will  long-term plans for using this capacity be affected?
• will the lower selling price influence other customers?