Special orders are one-time orders that businesses have the opportunity to fulfill outside of their normal business operations. Deciding whether a special order should be accepted or not, and at what price, is an important decision for managers. Managers look at incremental costs and benefits to determine whether a special order will provide positive incremental operating income for the business.
For example, Basement Specialist manufactures and sells construction materials for constructing, insulating and waterproofing basements and foundations in Hamilton. In the old part of the city, sewage and rainwater drain into the same sewer system. During high rainfalls, water levels in the sewer system rise and may backtrack into homes without one-way check valves on their sewer lines. As a result, the city of Hamilton has offered the Basement Specialist $2,000/each for the installation of 50 new check-valves.
The cost breakdown for installing a typical sewer check valve is as follows:
Direct materials $450
Direct labor $500
Administrative overhead $200
Job cost $1150
The variable portion of the above administrative overhead is $50 per job. To fulfill the contract, Basement Specialist would also have to hire a new project manager with a salary of $50,000 for the duration of the project. However, direct materials can be ordered in bulk, saving $100/unit. The special job may also bring in new contracts for other work done on some of these 50 homes. These jobs are expected to provide $150/home net of expenses on average.
The incremental operating income can be computed as follows:
|
|
Per Unit |
Total 100 Check-Valves |
|
Incremental revenue |
$2,150 |
$107,500 |
|
Incremental costs: |
|
|
|
Variable costs: |
|
|
|
Direct materials |
450 |
22,500 |
|
Direct labor |
500 |
25,000 |
|
Variable Manufacturing Overhead |
50 |
2,500 |
|
Special savings |
-100 |
- 5,000 |
|
Total variable cost |
$900 |
45,000 |
|
Fixed Cost: |
|
|
|
New project manager |
|
50,000 |
|
Total incremental cost |
|
95,000 |
|
Incremental operating income |
|
$9,500 |
Therefore, even though the price on the special order ($279) is below the normal unit product cost ($282) and the order would require incurring additional costs, the order would result in an increase in operating income. In general, a special order is profitable as long as the incremental revenue from the special order exceeds the incremental costs of the order.