Special-order decisions
/What are Special-Order Decisions?
Special-order decisions involve situations in which management must decide whether to accept unusual customer orders. These orders typically require special processing or involve a request for a low price. The ultimate point in dealing with special orders is whether the seller can generate some amount of incremental profit by agreeing to process the order. When making this decision, you must compare the incremental change in revenue for the seller, against which is offset the incremental change in costs. You must also consider whether there is a sufficient amount of incremental production capacity available that can be used to process the additional order.
Example of a Special-Order Decision
Hilton Furniture Company produces high-quality wooden chairs. Each chair normally sells for $200, and the variable cost per chair is $120. Fixed costs total $50,000 per month and are not affected by production levels. Hilton usually produces and sells 500 chairs per month, but it has additional capacity to produce up to 200 more chairs without incurring extra fixed costs.
A customer approaches Hilton with a one-time order for 100 chairs at $150 each (below the normal selling price). The customer will handle shipping, so no additional costs are incurred beyond the variable cost of production. The revenue from this order would be $15,000, while the variable cost would be $12,000, resulting in a contribution margin of $3,000. Since fixed costs remain unchanged, the contribution margin of $3,000 will directly increase Hilton’s profit for the month if the order is accepted.
The company should accept the special order if:
It has enough unused capacity to produce the additional 100 chairs.
The special order does not affect its ability to fulfill regular sales.
The special price does not undercut its reputation in the market.
If these conditions are met, accepting the special order will result in a $3,000 increase in profit.
Impact of Capacity on Special-Order Decisions
A common flaw made when dealing with special-order decisions is to not recognize that the order will take production capacity away from existing orders that generate a higher profit, resulting in a net decline in total profit for the business. Consequently, it is essential to model requests for special orders in the context of all other existing customer orders.
Impact of Non-Financial Considerations on Special-Order Decisions
When making a special-order decision, management may need to consider additional issues that are unrelated to the immediate financial impact. For example, the requesting customer might be a new one that could eventually place quite large orders with the company. If so, a special order that loses money might well be worth accepting, based on its long-run implications. Or, if the company wants to enter a new market niche and a special-order is in that niche, then the order might be accepted simply because it gains the company entry into that area. Alternatively, management might deny a special order because it is at an unusually low price point, and they do not want the company to gain a reputation for granting occasional low-price deals.