A special order is a one-time order made for one of the company's regular products at a requested reduced price. Companies will analyze this offer to determine whether to accept or reject it.
Continue to use the data from the previous two examples: The company normally sells its product for $30 per unit. It is approached by another company that offers to purchase 500 units at a price of $19 per unit. The company has not worked with this customer in the past and believes it is a one-time request.
Before the company can consider accepting this offer, it needs to make sure that it has excess capacity available to fill the order. Investopedia, LLC (2016, para. 1) defines excess capacity as "a situation in which actual production is less than what is achievable or optimal for a firm. This often means that the demand in the market for the product is below what the firm could potentially supply to the market." This means that the company can fill the order with idle manufacturing capacity.
The company will also need to make sure that the reduced price will be high enough to cover the differential costs of producing the units and that the order won’t affect long-term sales at the regular price.
The following information has been provided by the company:
| Special price offer | $19 |
| Variable expenses per unit: |
-
|
| Direct materials | $7 |
| Direct labor | $6 |
| Variable factory overhead | $5 |
| Variable selling expense | $2 |
| Total variable expenses | $20 |
| Fixed expenses: |
-
|
| Fixed factory overhead | $13,000 |
| Fixed selling and administrative expenses | $7,000 |
| Total fixed expenses | $20,000 |
| Unit sales for special order | 500 |
The company believes that accepting this order would not affect current sales at the normal selling price and would not affect long-term sales of the product. It has also determined that there is excess manufacturing capacity available to fill this order. Accepting this order will not affect fixed costs; therefore, fixed costs are not relevant to this decision. In addition, this order will not affect variable selling or administrative expenses; therefore, they can be ignored when making a decision.
A common mistake made in this type of analysis is using a per-unit dollar amount for fixed costs. Total fixed expenses for the company are $20,000; this will not change if it produces 500 additional units. Fixed costs per unit, on the other hand, will change with an increase (or decrease) in production. For example, assume that the company expects to produce 10,000 units to sell to its normal customers. The total fixed cost per unit would be $2.00 ($20,000 / 10,000 units). If the company would produce an additional 500 units to meet this special order, the total fixed cost per unit would decrease to $1.90 ($20,000 / 10,500 units). The total fixed cost per unit decreases by $0.10 per unit, but the company’s total fixed expenses remain $20,000. Fixed cost per unit is not relevant for this type of analysis.
The relevant costs for this decision are the variable manufacturing costs shown below:
| Direct materials | $7 |
| Direct labor | $6 |
| Variable factory overhead | $5 |
| Cost per unit | $18 |
Using the offer of $19 per unit and the relevant costs for this decision, the company prepared the following analysis:
| Sales | $19 | $9,500 |
| Variable costs: | - | - |
|
Direct materials
| $7 | $3,500 |
|
Direct labor
| $6 | $3,000 |
|
Variable factory overhead
| $5 | $2,500 |
| Total costs | $18 | $9,000 |
| Operating income | $1 | $500 |
Based on the estimates, the company believes that it will make $1 per unit for a total of $500 if it accepts the offer. Therefore, it decides to accept the offer to sell 500 units for $19.
Companies typically will accept an offer as long as revenue exceeds the variable expenses required to produce the units.
Investopedia, LLC. (2016). Excess capacity. In Reference: Dictionary. Retrieved from http://www.investopedia.com/terms/e/excesscapacity.asp