Accept or reject a special order

There 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 Capacity

In 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 Capacity

Using 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.

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.