Special Orders in Cost Accounting
In cost accounting, a special order is a one-time customer order, often involving a large quantity and a low price. This is a chance to make money or lose money. Tough choice.
A special order requires you to make decisions using relevant information. You decide which costs and revenue are relevant. Based on your analysis, you make a decision designed to maximize your profit.
Keep the following points in mind when you’re considering special orders:
Because you are already in business to produce other goods, assume that your fixed costs are being paid for from your regular production. Assume that you’ve received other orders, completed work, and billed clients. That revenue allows you to cover fixed costs — like a building lease payment or insurance premiums.
A special order can be filled only if you have excess capacity. You must have the ability to perform the work.
Get ready for this: You can accept a lower sales price for a special order and still be profitable. The fixed costs have already been paid for with earlier production. They are past (sunk) costs, so you do not need to worry about covering them with your special-order revenue.
Variable costs are a part of your special-order calculation. Variable costs are almost always relevant to a special order.
Say your company manufactures bath towels. Here are your results before you’re approached about a special order.
|Units Produced: 300,000||Per Unit||Total|
A customer wants to place an order for 50,000 towels. The customer is willing to pay only $8 per towel. Assuming you have excess capacity, would it be profitable to accept the order?
|Units Produced: 50,000||Per Unit||Total|
Actually, the order is profitable. Because fixed costs were covered by your other production, there’s no fixed cost related to this order. The variable costs per unit are the same ($7). At $8 per towel, the order generates a $50,000 profit. Think of anything above $7 as icing on the cake, because this is a sale that would not normally be part of your regular income stream.
Again, this order is a one-time deal. The 50,000 units in in the second table aren’t part of your normal production. Units in normal production incur fixed costs, and fixed costs are excluded from the special order. An $8 per-unit price wouldn’t cover the full cost of the product in normal production.
You exclude fixed costs from your special order because they’re already covered by your regular sales; however, an $8 unit price wouldn’t cover the full cost of the product in normal production.
Always think of fixed costs in total dollars. Although it’s good to also look at fixed costs on a per-unit basis, per-unit fixed costs can be misleading and lead to mistakes in analysis. Why? Because fixed cost per unit is always changing, depending on how many units you produce. Always consider the total costs.
The goal is to generate enough revenue to cover (pay for) the entire dollar amount of fixed costs. That concept is in the definition of contribution margin. Contribution margin pays for fixed costs. Whatever’s left over is profit.
You show a total dollar amount in your analysis because you’re trying to cover a dollar amount of costs. In the first table, you see fixed costs in dollars. The per-unit column is blank.
Certainly, you can analyze variable cost on a per-unit basis. That makes sense. You trace materials and labor to a unit. Fixed costs, on the other hand, normally are allocated as an indirect cost. Stick with the total fixed cost in dollars.