Special Order Decisions
Example 1 Special Order
Tony's T-Shirts
Assume Tony’s T-shirts makes shirts for local soccer, baseball, basketball, and other sports teams. The owner, Tony, purchases the shirts and prints graphics on the shirts for each team. The graphics were designed several years ago, so design costs are no longer incurred. On average, Tony sells 1,000 shirts each month.
Typical monthly financial data follow:
| Prices/Cost Per Unit | Summarized Cost | Total Monthly Data at 1000 Shirts | Monthly Income Statement | |
| Sales revenue | 20 | 20,000 | 20,000 | |
| Variable costs | ||||
| Direct materials | 8 | 8,000 | ||
| Direct labor | 2 | 2,000 | ||
| Manufacturing overhead | 3 | 3,000 | ||
| Total variable costs | 13 | 13,000 | ||
| Contribution margin | 7 | 7,000 | ||
| Fixed costs (rent,salaries,etc.) | 4,000 | |||
| Profit | 3,000 |
The monthly information provided relates to the company’s routine monthly operations. A representative of the local high school recently approached Tony to ask about a one-time special order. The high school will be hosting a statewide track and field event and is willing to pay Tony’s T-shirts $17 per shirt to make 200 custom T-shirts for the event. Because enough idle capacity exists to handle this order, it will not affect other sales. That is, Tony has the factory space and machinery available to produce more T-shirts Tony incurs the same variable costs of $13 per unit to produce the special order, and he will pay a firm $600 to design the graphics that will be printed on the shirts. This special order will have no other effect on Tony’s monthly fixed costs.
Question: Should Tony accept the special order?
Answer: Let’s use differential analysis to answer this question. As shown in the following Table Special Order Differential Analysis, Alternative 1 assumes Tony rejects the special order, and Alternative 2 assumes he accepts the special order. The differential analysis in the Table Special Order Differential Analysis shows that Tony’s would be better off accepting the special order, as profit increases $200.
| Special Order Differential Analysis | Alternative 1 reject special order | Alternative 2 accept special order | Differential amount | Alternative 1 is |
| Sales revenue | 20,000 (a) | 23,400 | (3,400) | Lower |
| Variable costs | 13,000 (b) | 15,600 | (2,600) | Lower |
| Contribution margin | 7,000 | 7,800 | (800) | Lower |
| Fixed costs | 4,000 | 4,600 (c) | 600 | Lower |
| Profit | 3,000 | 3,200 | (200) | Lower |
(a) $23,400 = $20,000 + ($17 per shirt × 200 shirts).
(b) $15,600 = $13,000 + ($13 × 200 shirts).
(c) $4,600 = $4,000 + $600 cost for special order design.
The Table Summary of Differential Analysis provides an alternative presentation of differential analysis for Tony’s T-shirts. As discussed earlier in the chapter, this presentation summarizes the differential revenues and costs.
Summary of Differential Analysis for Tony’s T-Shirts
| Accepting Special Order | |
| Sales revenue increase | 3,400 |
| Variable costs increase | (2,600) |
| Contribution margin increase | 800 |
| Fixed costs increase:graphic design | (600) |
| Profit increase from accepting special order | 200 |
Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.
The Summary of Differential Analysis for Tony’s T-Shirts above shows the differential revenues and costs for the special order being considered. If Tony’s T-shirts accepts the special order, sales revenue will increase $3,400 with a corresponding increase in variable costs of $2,600. Fixed costs will increase by $600 because design work is required for the special order. Thus profit will increase by $200 (= $3,400 − $2,600 − $600).
Special Order Assumptions
Question: What assumptions were made with the differential analysis performed for Tony’s T-shirts?
Answer: We made two important assumptions in the Tony’s T-shirts special order example.
The first assumption is that Tony’s has enough idle capacity to handle the order without disrupting regular customer orders. Suppose Tony’s T-shirts is operating at capacity and cannot produce any more T-shirts. Tony must turn away regular customers to make room for the special order. In this scenario, the opportunity cost of turning away existing customers must be considered in the differential analysis.
The second assumption is that this is a one-time order, and therefore represents a short-run pricing decision. If Tony’s T-shirts expects future orders from the high school at the $17 per shirt price, the company must consider the impact this might have on long-run pricing with other customers. That is, regular customers may hear of this special price and demand the same price, particularly those customers who have been loyal to Tony’s T-shirts for many years. Tony’s might be forced to lower prices for regular customers, thereby eroding the company’s profits over time. The key point is that companies evaluating special orders can drop prices in the short run to cover differential variable and fixed costs. But in the long run, prices must cover all variable and fixed costs.
Example 2 Special Order
Quicko's
The following monthly financial data are for Quicko’s, a company that makes photocopies for its customers. On average, Quicko’s makes 100,000 copies each month.
| Cost Per Unit | Total Monthly Data at 100,000 Copies | |
| Sales revenue | .08 | 8,000 |
| Variable costs | .05 | 5,000 |
| Contribution margin | .03 | 3,000 |
| Fixed costs | 2,000 | |
| Profit | 1,000 |
Quicko’s is approached by a local restaurant that would like to have 20,000 flyers copied. The restaurant asks Quicko’s to produce the flyers for 7 cents a copy rather than the standard price of 8 cents. Quicko’s can produce up to 130,000 copies a month, so the special order will not affect regular customer sales. Variable costs per copy will remain at 5 cents, but production of the restaurant flyers will require a special copy machine part that costs $250. This special order will have no other effect on monthly fixed costs.
1. Using the differential analysis format presented in the previous example Special Order Differential Analysis for Tony’s T-Shirts, determine whether Quicko’s would be better off accepting or rejecting the special order.
2. Summarize the result of accepting the special order using the format .
Using the differential analysis format , determine whether Quicko’s would be better off accepting or rejecting the special order.
| Special Orders Differential Analysis | Alternative 1 reject special order | Alternative 2 accept special order | Differential Amount | Alternative 1 is |
| Sales revenue | 8,000 | 9,400 (a) | (1,400) | Lower |
| Variable costs | 5,000 | 6,000 (b) | (1,000) | Lower |
| Contribution margin | 3,000 | 3,400 | (400) | Lower |
| Fixed costs | 2,000 | 2,250 (c) | 250 | Lower |
| Profit | 1,000 | 1,150 | (150) | Lower |
(a) $9,400 = $8,000 + ($0.07 per copy × 20,000 copies);or alternative approach: ($0.08 per copy × 100,000 copies) + ($0.07 per copy × 20,000 copies).
(b) $6,000 = $5,000 + ($0.05 per copy × 20,000 copies); or alternative approach: $0.05 × 120,000 copies.
(c) $2,250 = $2,000 + $250 cost for copy machine part.
This analysis shows that Quicko’s would be better off accepting the special order because profit is $150 higher for Alternative 2
| Result of Accepting Special Order | |
| Sales revenue increase | 1,400 |
| Variable costs increase | (1,000) |
| Contribution margin increase | 400 |
| Fixed costs increase:copy machine part | (250) |
| Profit increase from accepting special order | 150 |
Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.
Assume that Quicko’s only has a capacity of 100,000 copies instead of 120,00 copies per month and that regular customer sales would decrease as a result of the special order.
This analysis shows the company would be better off rejecting the special order because profit is $450 higher for this alternative.
Note:This illustrates the effect capacity constraints can have on a special order decision.
| Special Order Differential Analysis | Alternate 1 reject special order | Alternate 2 accept speciaal order | Differential Amount | Alternative 1 is |
| Sales revenue | 8,000 | 7,800 (a) | 200 | Higher |
| Variable costs | 5,000 | 5,000 | 0 | |
| Contribution margin | 3,000 | 2,800 | 200 | Higher |
| Fixed costs | 2,000 | 2,250 (b) | (250) | Lower |
| Profit | 1,000 | 550 | (450) | Higher |
(a) $7,800 = ($0.08 × 80,000 regular customer copies) + ($0.07 × 20,000 special order copies).
(b) $2,250 = $2,000 + $250 cost for copy machine part.