Short Term Decision Making-Special Order(Part5)

Simple Illustration:

Say Company A has capacity to produce 100,000 units of product X. The cost estimate per unit based on current capacity of 80% is as follows:

$ per unit

Direct material $2.00

Direct labor $5.00

Variable production overhead $3.00

Fixed production overhead $4.00

Total $14.00

The company sells the product X to its regular customer at $20.00. However,a non- regular customer has approached the company to purchase the excess capacity at $18 each.

Question:Should Company A accept this special order?

Solution:

If the special order is accepted:

Incremental revenue ( 20% x 100,000 x $18) $360,000

Less:

Incremental cost

Direct material ($2.00 x 20,000) $40,000

Direct labor ($5.00 x 20,000) $100,000

Variable production o/h ($3.00 x20,000) $60,000

Total incremental cost $200,000

Incremental profit $160,000

(PS:the above takes only the relevant costs hence ignoring fixed production overheads as it is still below 100% production capacity)

Salient points on Qualitative factor to consider:

• In the above case,we have assumed that there is spare capacity but it’s important to ensure that there is really sufficient capacity before agreeing on special order;
• Ask whether there is any better alternative than accepting special order;
• By accepting special order,needs to ensure that this special order does not affect customer loyalty or affecting the status quo of the existing product,in the above case is product X. Basically,we should not endanger the existing products by wanting to utilize full production capacity.