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Recommended textbook solutions Intermediate Accounting14th EditionDonald E. Kieso, Jerry J. Weygandt, Terry D. Warfield 1,471 solutions Essentials of Investments9th EditionAlan J. Marcus, Alex Kane, Zvi Bodie 689 solutions Accounting23rd EditionCarl S Warren, James M Reeve, Jonathan E. Duchac 2,210 solutions Principles of Auditing and Other Assurance Services18th EditionKurt Pany, O. Ray Whittington 244 solutions A special order is a unique, one-time order made by a customer that requires a variation in the manufacture of your regular products. Your accounting staff should analyze the proposal and determine whether to accept or reject the special order. This will be based on sales revenue, costs of production and the long-run implications of additional costs to accommodate special orders, as you may have to either leverage idle capacity or drop a process segment if you face resource constraints. TipWhen there is idle capacity or when sales are low, you can accept special orders as long as the incremental revenue surpasses incremental costs. When production is running at full capacity, more calculations are required in decision making. Acceptance of a Special OrderA special order will typically involve a large quantity of products or service at a specified price. Your accounting manager's feedback will hinge on how to maximize your profit. The proposal should be accepted only if the incremental revenue associated with the special order exceeds incremental costs and if present sales will be unaffected. With fixed costs already accounted for in regular production, you will need to optimize the price point based on the variable costs to turn a profit. Soft benefits, like maintaining a business relationship, should be considered as well. Idle CapacityIn order to complete the special order, your company must have the ability to perform the task. To avoid disrupting production, you need to have the capacity to fill the special order in terms of personnel and equipment on the production line. If you're operating at full capacity, you'll have to turn away regular customers to accommodate the special order. This can only be justified if the order produces a large enough profit to overcome the disruption. Special Order PricingSince a special order is a one-time order, it represents a short-run pricing decision. Use the special order pricing technique to ensure profit – calculate the lowest price of the product or service at which to accept the special order. Even if the price is set below regular price, the sale may still generate a profit above variable costs. When there is idle capacity or when sales are low, you can accept special orders as long as the incremental revenue surpasses incremental costs. Example of Accounting Decision MakingSuppose your company manufactures caps for sports brand names and currently produces and sells 100,000 units. Your monthly fixed cost is $300,000 and the variable cost per cap is $4, comprising $3 for the material and $1 for labor. Sports retailers purchase each cap for $10. Assume you receive a special order for 15,000 caps at $9 each. Regardless of whether you take the special order, you will incur the fixed cost. The same variable costs of $4 per unit apply and the special order will cost $60,000 to produce and sell for $135,000. With idle capacity you'll make 115,000 units, generating a profit of $375,000 instead of the regular $300,000. At full capacity, you displace 15,000 regular units, realizing an opportunity cost of $90,000 and a profit of $285,000. Decision ConsiderationsThere are times when a customer places a special order for a large volume at lower prices than that usually charged by the business. In this event, the business should properly decide whether to accept or reject the special order. When the company is operating at less than its maximum capacity and the company has enough capacity to produce and fill the special order, the order should be accepted if the additional sales exceed the additional variable costs. When the company has no excess capacity, the cost to be considered must include the lost contribution margin from sacrificing regular sales to be able to fill up the special order. Example - With Excess CapacityIn a month, ABC Company normally produces and sells 8,000 units of its product for $20. Variable manufacturing cost per unit is $10. Total fixed manufacturing costs (up to the maximum capacity of 10,000 units) are $38,000. Variable operating cost is $1 per unit and fixed operating costs total $10,000. A customer placed a special order for 1,500 units for $15 each. The customer is willing to shoulder the delivery costs; hence the business will not incur additional variable operating costs. Should the company accept or reject the special order? Solution: The company has 2,000 units excess capacity to fill up the special order of 1,500 units. The only costs to be considered in this case are the variable manufacturing costs. The total fixed cost is the same regardless of the level of activity. Even if an additional 1,500 units are to be produced, the total fixed cost remains the same. In addition, both parties agreed that the company will not incur in additional variable operating costs. Should the company accept the offer? Yes. The selling price of $15 exceeds the variable manufacturing cost of $10. This will result in additional income of $7,500 (1,500 x $5). Proof:
The $182,500 sales revenue includes 8,000 units sold at $20 and 1,500 units sold at $15 each. Additional variable operating costs is avoided as mentioned in the problem. Fixed costs remain constant regardless of the level of activity. Example - Without Excess CapacityUsing the same information in the above scenario but this time, assume that the company normally manufactures and sells 9,000 units instead of 8,000. Should the company accept the special order? Solution: Since the company has excess capacity of 1,000 units only, it is not enough to fill up the special order of 1,500 units. Hence, a portion of the regular sales (500 units) must be sacrificed to fill up the entire special order. The lost contribution margin should be considered. Contribution margin is equal to sales (at $20) minus variable costs ($10 variable manufacturing plus $1 variable operating). Lost contribution margin = ($20 - $11) x 500 units = $4,500 The lost contribution margin is allocated over the items sold through the special order. Lost contribution margin per unit = $4,500 / 1,500 units = $3 This cost is an additional consideration in the decision. Should the company accept the offer? The answer is still yes since the selling price ($15) is higher than the cost ($13, i.e. variable manufacturing cost per unit of $10 plus lost CM per unit of $3). This will result in additional income of $3,000 (1,500 x $2). Proof:
The $192,500 sales revenue includes regular sales of 8,500 units (sold at $20 each) and 1,500 specially ordered units (sold at $15). As mentioned in the problem, the company will incur the variable operating cost only for regular sales. Fixed costs remain the same. Key Takeaways The general rule is to accept a special order if the benefits exceed costs. Otherwise, turn down respectfully. If the business has excess capacity to fill the special order, it would accept if incremental sales revenue exceeds incremental variable costs. If it has no excess capacity, the incremental sales revenue should exceed incremental variable costs plus opportunity costs for cancelling normal orders to free up capacity for the special order. Web link APA format Accept or reject a special order (2022).
Accountingverse. Next Lesson → Previous Lesson ← Chapter Outline ≡ What qualitative factors should consider before accepting or rejecting a special order?When deciding whether to accept a special order, management must consider several factors:. The capacity required to fulfill the special order.. Whether the price offered by the buyer will cover the cost of producing the products.. The role of fixed costs in the analysis.. Qualitative factors.. What are qualitative factors in decision making?Examples of qualitative factors include customer satisfaction with a company's products, pending litigation that harms a company's reputation, a change in a company's management, the relationship the company has with key vendors, or ownership of a new technology that gives the company a competitive advantage.
When making a decision to accept a special order management must consider?When making this decision, one must compare the incremental change in revenue for the seller, against which is offset the incremental change in costs. One must also consider whether there is a sufficient amount of incremental production capacity available that can be used to process the additional order.
Which of the following is not one of the factors company considers when accepting a special order?Answer and Explanation: The answer is D. Sunk costs. Factors that should be considered when accepting a special order are all relevant costs, the excess capacity, and other qualitative aspects that need to be accounted for.
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What are the qualitative factors in considering in accepting or rejecting a special order?
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