Question

Explain and compare two(2) examples of special order(accepting a special order and rejecting a special order) for a sample bussiness decision for a company.

Rejecting a special order) for a sample business decision for a company

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Answer 1

Production or service industries may often encounter a situation where they have to decide on whether to accept a special order or reject it. The decision is mainly based on if it's financially viable or not.

We begin by verifying if there is excess capacity available or not. In case there exists, the relevant costs for decision purposes is the variable cost of production. Fixed Costs aren't relevant because they have recovered in existing production.

However there is no excess capacity we have to verify if sacrifice a part of the existing production to manufacture the special order. Hence the relevant cost here could be the variable as well as a portion of fixed costs and the opportunity cost ie the profits lost from sacrificing the production of existing units.

Sometimes we may have to incurr additional or one-time expenses exclusively for the special order. These expenses have to be considered for decision of acceptance or not.

The above can be understood with the help of following example:

A Ltd receives a special order from B Ltd for 5,000 units of XX at $ 12 per unit. A currently produces 15,000 units of XX sold at $ 15 per unit and has available capacity of 20,000 units. The variable cost of XX is as following:

• Direct Material 1 kg @ $ 5/kg
• Direct Labor 0.5 Hour @ $ 5/ hour
• Variable manufacturing overhead @ 2/hour

Fixed costs are $ 75,000. The additional set up cost exclusively for special order is $ 10,000. Decide whether to accept the new order or not.

Solution:

Computation of financial advantage/(disadvantage) of Special order

Sales (5,000*12)	60,000
Less: Variable costs
Direct Material ($ 5*5,000)	(25,000)
Direct Labor (0.5*$ 5*5,000)	(12,500)
Variable manufacturing overhead (0.5*$ 1*5,000)	(2,500)
Contribution	20,000
Less: Fixed Costs (already recovered with existing production, except additional set up costs)	(10,000)
Financial Advantage/(Disadvantage)	10,000

Thus the order can be accepted.

Example 2: Suppose the above facts remain except for available capacity is 15,000 units, decide to accept the special order or not.

Solution: Thus, fixed costs becomes relevant cost for decision making as we have to forego the production of 5,000 existing units to produce special order. Thus,

Computation of Financial advantage/(disadvantage)

Contribution (as above)	20,000
Less: Fixed Costs (75,000/15,000*5,000)	(25,000)
Set Up costs	(10,000)
Financial disadvantage	(15,000)

Hence the order should be rejected.