Formulation of the problem
A special order decision requires managers to decide whether to accept or reject an order which is outside the scope of normal sales.
A special order is an exceptional request from a customer which may entail a different price or different costs due to customization of the product or service. It is a one-time order that is not considered part of the company’s normal ongoing business.
When dealing with a special order, managers must fundamentally ask three questions: does the company have enough idle capacity to satisfy the order without sacrificing normal sales? What would be the changes in revenues, variable costs (and thus contribution margin), and fixed costs? What are the other qualitative factors which should be taken into account? We will now review each point separately.
Classification based on relevance
If there is no binding capacity constraint, the special order just brings an additional contribution margin which is equal to the volume of that order multiplied by its specific unit contribution margin (keep in mind that the price and unit variable cost are likely to differ from those of normal sales because of their specificity). It may also sometimes increase slightly fixed costs. In any case, it can be accepted as long as incremental revenues exceed incremental costs.
However, if idle capacity is insufficient to satisfy both the special order and normal sales, there is an opportunity cost to accepting the order. Indeed, accepting it results in the inability to produce enough units to satisfy normal sales. The contribution margin on normal sales which have to be sacrificed must therefore be counted as an additional cost of the special order.
Net Economic Impact and indifference points
For this exercise, you can download here data and solutions if you did not already. The scenario is the following: a group of teachers want to arganize a coktail party with Mojitos exclusively. They expect a consumption of 2,000 Mojitos - it is a massive party… Since they are quite price sensitive (especially the management accounting teacher who is negotiating with you) and also a bit difficult, they want to pay 6.5 euros per Mojito (instead of 7 for normal sales) and made a request for extra mint and lime, increasing the unit variable cost by 0.5 euros. Since you were also suffering from a shortage of labor, you also have to hire waiters and waitress for the occasion, increasing your fixed costs by 1,500 euros. However, you could not acquire more rum, so the quantity still available remains a constraint. Try to answer the following questions:
This kind of analysis should only be done for one-time orders as recurrent orders might affect normal prices as well. Among the strategic factors to consider, managers should be careful about potential side effects on current customers (especially if normal sales are sacrificed) or prices, as well as the desire to do new business or the possibility of future orders with the customer making the special order. Sometimes a loss can pave the way for a profitable relationship.
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