What is a Special Order Decision?

Special Orders in this Accounting Unit context refers to when a customer requests to place an order that is below the retail price but at a large volume. On a purely monetary basis, we should accept special orders if we have the capacity to fulfil the order and it increases our overall profitability.

For example, we are banana grower that sells bananas for $3 each and it costs us $1 to produce a banana. If a customer says they will be 10,000 units at $2 each, if we have the bananas available, we would accept this order as we would still make a profit of $10,000. However, we may have capacity constraints, making the decision more complex.

Dealing with Capacity Constraints in a Special Order Decision

If we have a production capacity, to determine whether we accept the order we need to calculate the contribution margin of both scenarios; no special order and accepting the special order.

With the previous example, we are banana grower that sells bananas for $3 each and it costs us $1 to produce a banana. A customer would like to purchase 10,000 units at $2 each.

If our production capacity was 18,000 units and we are expected to sell 15,000 units at the retail price, should we accept the special order?

Solution

Step 1: Calculate the Contribution Margin

Assuming No Special Order Expected Regular Sales: 15,000 units Sale Price: $3 per unit Variable Cost: $1 per unit Contribution Margin = (Selling Price Per Unit - Variable Cost Per Unit) * Units Sold

Contribution Margin = ($3 - $1) * 15,000 = $30,000

If we do not accept the order, we are expected to make $30,000 in contribution margin towards fixed costs.

Step 2: Calculate the Contribution Margin with Special Order

Our production constraint is a maximum of 18,000 units. If we accept the special order of 10,000 units, we will have to reduce our regular sales to 8,000 units.

Max Regular Sales = Capacity Constraint - Special Order Sales

Max Regular Sales = 18,000 - 10,000 = 8,000 units

Special Order Sales: 10,000 units at $2 sale price each

Regular Sales: 8,0000 units at $3 sale price

Sales Revenue = (10,000 units *$2) + (8,000 units * $3)

Sales Revenue = $20,000 + $24,000 = $44,000

Variable Cost = 18,000 units * $1 per unit = $18,000

Contribution Margin = Sales - Variable Cost

Contribution Margin = $44,000 - $18,000 = $26,000

Step 3: Compare

Contribution Margin Without Special Order = $30,000

Contribution Margin With Special Order = $26,000

The contribution Margin is lower by $4,000 with the special order, therefore we should reject the special order.

What are the Other Factors You Need to Consider in a Special Order Decision?

What are some other factors we need to consider if a Special Order produces a higher contribution margin?

1. Expandability of Production: Accepting a special order could place production close or at its maximum capacity. This could be unfavourable for the business if it sees a surge in demand as it cannot achieve the greatest possible contribution margin per unit.

2. Affect on Existing Customer Orders: For special order decisions that lower the sales for regular/existing customers, could have a negative effect on customer loyalty. Failure to fulfil an order could see a customer not returning to the business.

3. Pressure on Sales Price: If a customer is able to purchase the goods at a lower price, existing customers could place pressure on the business to offer the same or lower price. As a result, if sales prices are lowered for existing customers, this could have a negative effect on the long-term profitability of the business

Worked Example: Special Order Decision

Question:

New Nikeys are a Shoe Producer. They sell on average 25,000 units of shoes, but have capacity to produce 32,000 shoes. The shoes retail for $25 each and cost $15 to produce. A large customer has asked the Company to produce a special order of 12,000 shoes to be sold at a price of $20 each.

Should the Company Accept the Special Order?

Solution:

Step 1: Calculate the Contribution Margin

Assuming No Special Order Expected Regular Sales: 25,000 units

Sale Price: $25 per unit

Variable Cost: $15 per unit

Contribution Margin = (Selling Price Per Unit - Variable Cost Per Unit) * Units Sold Contribution Margin = ($25 - $15) * 25,000 = $250,000

If we do not accept the order, we are expected to make $250,000 in contribution margin towards fixed costs.

Step 2: Calculate the Contribution Margin with Special Order

Our production constraint is a maximum of 32,000 units. If we accept the special order of 12,000 units, we will have to reduce our regular sales to 20,000 units.

Max Regular Sales = Capacity Constraint - Special Order Sales

Max Regular Sales = 32,000 - 12,000 = 20,000 units

Special Order Sales: 12,000 units at $20 sale price each

Regular Sales: 20,000 units at $25 sale price

Sales Revenue = (12,000 units *$20) + (20,000 units * $25)

Sales Revenue = $240,000 + $500,000 = $740,000

Variable Cost = 32,000 units * $15 per unit = $480,000

Contribution Margin = Sales - Variable Cost

Contribution Margin = $700,000 - $480,000 = $260,000

Step 3: Compare

Contribution Margin Without Special Order = $250,000

Contribution Margin With Special Order = $260,000

The contribution Margin is higher by $10,000 with the special order, therefore we should accept the special order on a purely monetary basis.