Accepting Special Order
Understanding Special Orders
A special order is a unique, one-time request from a customer to purchase goods or services at a price that is typically lower than the standard selling price. Businesses often face decisions regarding whether to accept these orders, which can significantly impact their profitability and operational capacity.
Good business management requires keeping the cost of idleness at a minimum. When operating at less than full capacity, management should seek additional business. Management may decide to accept such additional business at prices lower than average unit costs if the differential revenues from the additional business exceed the differential costs. By accepting special orders at a discount, businesses can keep people employed that they might otherwise have to lay off.
Factors Influencing the Decision
- Capacity Considerations:
The first step in evaluating a special order is determining if the company has sufficient capacity to fulfill it without disrupting regular operations. If the business operates below its maximum capacity, it may be feasible to accept the order as long as it covers variable costs. For instance, if a company can produce 10,000 units but only sells 8,000, accepting an order for an additional 1,500 units may be beneficial if the selling price exceeds variable costs
- Cost Analysis:
When assessing a special order, businesses should conduct a differential analysis to compare incremental revenues against incremental costs. This includes variable manufacturing costs and any additional fixed costs incurred due to the special order. For example, if a company incurs $10 in variable costs per unit and receives an offer of $15 per unit for a special order, it would generate an additional contribution margin of $5 per unit.
- Opportunity Costs:
If fulfilling the special order requires sacrificing regular sales (due to limited capacity), opportunity costs must be considered. This involves calculating the lost contribution margin from regular sales that cannot be fulfilled because resources are allocated to the special order. For instance, if fulfilling a special order means reducing regular sales by 500 units, and each unit contributes $4 towards fixed costs, this lost contribution must be factored into the decision.
- Long-term Implications:
Companies should also consider potential long-term effects of accepting special orders at lower prices. If customers perceive that they can obtain products at reduced rates through special orders, they may expect similar pricing in future transactions or from other customers[2]. This could lead to pressure on pricing strategies across all sales channels.
- Profitability Assessment:
Ultimately, the decision hinges on whether accepting the special order will enhance overall profitability. If incremental revenues exceed incremental costs—including any opportunity costs—then accepting the order is advisable.
Conclusion
In summary, the decision to accept a special order should be based on careful consideration of capacity constraints, cost analysis including both variable and opportunity costs, and potential long-term implications for pricing strategy and customer relationships. By ensuring that these factors are thoroughly evaluated using differential analysis techniques, businesses can make informed decisions that align with their financial goals.
Analysis Tools Used