Question

Knorr’s Knob Company produces 5,000 doorknobs a month, which is 90% of factory capacity. Variable manufacturing costs are $4 per unit. Fixed manufacturing costs are $10,000 per month. Knobs are usually sold for $20 apiece. Ms. Knorr has just received a special order from Uganda Home Supplies to produce an extra 500 knobs for $2,200. Should Knorr accept the order? Discuss all important assumptions/criteria which must be considered in a decision like this (make a fully developed argument/recommendation).

Answer 1

When the company is not operating at its full capacity and has enough capacity to fulfill any special order then the special order should be accepted if revenue from the special order covers the variable cost .Fixed will not effect this decision as it remains the same regardless of the level of activity.

In this question, Knorr's Knob company is producing 5,000 doorknobs at 90% capacity which means it can produce around 5,555 doorknobs ( 5000/90*100) at 100% capacity. Now, company has received a special order from Uganda Home supplies to produce an extra 500 knobs for $ 2,200. Knorr's Knob company has an excess capacity to produce these 500 units so no additional fixed cost would be incurred to fulfiill the special order, the only cost which would vary is the variable cost.

Let us perpare a differential analysis to decide whether this special order should be accepted or rejected:

	Accept the order	Reject the order	Differential effect on Income
Revenue	$ 102,200 (1)	$ 100,000	$ 2,200
Less: Variable manufacturing costs	($ 22,000) (2)	($ 20,000)	($ 2,000)
Contribution margin	$ 80,200	$ 80,000	$ 200
Less: Fixed costs	$ 10,000 (3)	$ 10,000	0
Operating Income	$70,200	$ 70,000	$ 200

The above differential analysis shows that the additional revenue of $ 2200 from the special order exceeds the additonal variable manufacting cost of $ 2000 and therefore company would be earning $ 200 more if they accept the special order so Knorr’s Knob Company should accept the order.

Working Notes:

(1) Total Revenue when accept the order = 5,000 doorknobs * $ 20 + $ 2,200 = $ 102,200

(2) Total variable manufacturing cost when accept the order = 5,000 * $4 + 500 * $4 = $ 22,000

(3) Fixed cost will remain same in both the situations so it will be $ 10,000 even if the company accepts the order.