Sometimes, when a company has spare production capacity, it is willing to fulfill SPECIAL ORDERS for non-regular customers. Normally, the prices quoted are lower than those regular customers.

So When do a Company Accept or Reject a Special Order?

Generally, the rule is to accept the order as long as the incremental revenue is MORE than the incremental costs since this will result in incremental profit

Incremental Revenue =Special Order units x Special Order price

Incremental Costs= Variable costs +extra fixed overheads + opportunity costs that relates to the production of that special order

Incremental Profit =Incremental Revenue-Incremental Cost

Illustration:

Assuming Company A has capacity to produce 100,000 units of product X. The cost estimate per unit based on current capacity of 80% is as follows:

$ per unit

Direct material $2.00

Direct labor $5.00

Variable production overhead $3.00

Fixed production overhead $4.00

Total $14.00

The company sells the product X to its regular customer at $20.00. However, a non- regular customer has approached the company to purchase the excess capacity at $18 each.

Question: Should Company A accept this special order?

Solution:

If the special order is accepted:

Incremental revenue ( 20% x 100,000 x $18) =$360,000

Less:

Incremental cost

Direct material ($2.00 x 20,000) $40,000

Direct labor ($5.00 x 20,000) $100,000

Variable production o/h ($3.00 x20,000) $60,000

Total incremental cost $200,000

Incremental profit $160,000

(PS: the above takes only the relevant costs hence ignoring fixed production overheads as it is still below 100% production capacity)

• ask whether there is any better alternative than accepting special order;
• by accepting special order, needs to ensure that this special order does not affect customer loyalty or affecting the status quo of the existing product, in the above case is product X. Basically, we should not endanger the existing products by wanting to utilize full production capacity.

REASONS TO BUY FROM OUTSIDERS

·  Flexibility to meet urgent demand of customers;

· Overcome limiting factor problem ( Part 1);

· Concentrate on its own core competencies;

· Take advantage of the specialist skill and expertise of the outsiders;

·Overcome production bottleneck and

·Solve seasonal demand problem

COMPARE BETWEEN THE RELEVANT COST OF MAKE OR BUY

If it is cheaper to make, the company should manufacture internally and

If it cheaper to buy then the company should buy from the outsiders

The relevant costs involve the following:

RELEVANT COSTS OF MAKING

=

Variable Cost of Manufacturing like direct materials, direct labors and variable production overheads

+

Any increase in specific Fixed costs

+

Any Opportunity cost involved

RELEVANT COSTS OF MAKING

=

Purchase price

+

Any direct costs relating to purchasing

Ilustration:

Company A has to decide whether to manufacture internally or to buy or contract from outsiders.

Company A is able to contract with another company to supply them ready make at $5 each.

The details of Company A internal production costs are as follows:

Direct material/unit $2.00

Direct labor/unit $3.00

Variable production overhead $0.50

Fixed production overhead $0.50

Total production per unit cost $6.00

The company also need to pay for transport charges of $2,000 for the delivery of 3,000 units of the product.

Question : Should Company A make or buy the product?

Solution:

Relevant cost of Making

=Direct material + Direct Labor + Variable Production OH

=($2 + $3 + 0.50) x 3,000 units

=$16,500

Relevant cost of Buying:

= Purchase cost + Transport cost

= ($5 x 3,000) + $5,000

=$20,000

Therefore, it is better for Company A to manufacture internally.

Salient Points to note:

In a Make or Buy situation, there are certain factors to consider:

·      The quality of the products been purchased externally;

·      Whether delivery time is able to be met and

·      Customer loyalty might be affected if sales are forgone due to cases of full capacity

CONTRIBUTION PER LIMITING FACTOR

Whichever product that gives the highest UCM per LF will given the highest rank.

The highest rank will be given the highest priority to be produced using the available resources.

The remaining resources will then be used to produce the next ranking products until all the resources are used up.

Illustration:

The below illustration assumes a shortage of direct labor as the limiting resource constraint.

The details of the company’s three product lines are as follows:

Products:               A       B    C

Selling price:        $50  $40 $30

Variable costs:      $20 $20 $20

Unit Contribution: $30 $20 $10

Expected demand 1,000units;500units; 600units

To produce 1 unit of product, the direct labor hours for each product is:

Product A : 10 hours; Product B : 5 hour Product C: 1 hour

Due to unavailability of labor supply, for the forthcoming period, it is assumed that the overall shortage of labor hours is 1,100 hours.

Question:

Determine the production mix to maximize the company’s profit.

Solution:

(1) Compute the Contribution per limiting factor

Contribution per Limiting Factor

=Unit Contribution/ No of hour to make the product

Product A:Unit Contribution $30 /10 hours = 3

Product B:Unit Contribution $20/5 hour = 4

Product C: Unit Contribution $10/1 hour =10

(2) Rank the Contribution per limiting factor ( highest ratio of contribution per limiting factor)

Product A =Rank No 3

Product B =Rank No 2

Product C =Rank No 1

(3) Determine the overall total hours to produce ALL products A,B & C and what is the shortage:

= Expected demand x No of hours

Product A=1,000 units x 10hours =10,000 hours

Product B=500 units x 5 hour = 2,500 hours

Product C=600 units x 1 hour = 600 hours

Total Direct Hours to produce All products =13,100

Total Available hours due to constraint =12,000

Shortage of (1,100) hours

(4) Using the Rank as per item 2 ,do the allocation of the available 12,000 ( 1,100 hours shortage) :

Total labor available = 12,000

Less:

Rank No 1: Product C = (600)hours =600 units

Rank No.2 roduct B =(2,500)hours =500 units

Rank No 3: Product C =(8,900)hours =8,900/10=890 units

Therefore the appropriate production mix is:

Product C: 600 units

Product B: 500 units

Product A: 890 units

Notional Costs

Notional costs are also known as imputed cost. The primary objective of charging notional costs is to enable management to make clearer internal decisions by making sure that internal decision making become more realistic by assuming that the cost of all resources consumed reflects the full economic value – usually by applying market prices.

• Notional charges are typically used to charge responsibility centres.

• Notional interest is often charged for the use of internally generated funds.

Examples of using notional cost to enhance internal management making decisions:

• Charging of ’market rent’, where buildings have been purchased on a freehold basis. Such a mechanism helps to focus management attention on making best use of space so that surplus space across the whole organisation might then be sold or rented to another user.

• Intra division charges to enable management to see the “true” performance of certain departments

Sunk Costs:

Sunk cost is defined by ICMA terminology as

A past cost not directly relevant in decision making.

• If we refer to relevant costs, the main feature is that we are referring to FUTURE costs.
• As Sunk costs are cost which have already been incurred therefore it should be ignored when making any decisions.
• Sunk costs are irrelevant costs which are simply  costs that will not affect the decision.
• By analyzing these type of sunk costs, management will be wasting their time and efforts as these costs do not affect the decision they are going to make.

In short term decision making, fixed costs are generally regarded as sunk costs.

Illustration:

Say Company A has a factory which produced product A. Earlier last year it has extended and renovated the factory at an additional cost of $200,000 to produce product B. Now management is thinking of whether to let outsiders produce product B or not. Should this $200,000 be considered?

$200,000 is sunk costs which existed as a result of previous decision.

Committed Costs:

• These costs are similar to sunk costs in that they exist as a result of previous decisions although the ‘charge’ has yet to be incurred or the cash released.
• Committed costs are costs that have been committed by management.
• Examples are like renovation of factory premises, capital expenditures being incurred as company’s purchase orders have been issued or workdone is partially completely and payment to suppliers still outstanding

However, the abovementioned costs committed contractually is effectively a sunk cost.

Illustration:

Question:

Say company A is unable to rent out its building/workshop but there is a need to sign off a contract to spend $70,000 on an air conditioning system. Would this make any difference to management decision?

Answer:
None whatsoever. This type of situation might be awkward but past costs (and mistakes) should not impact upon the logic of financial decision making. The $70,000 that has been committed contractually is effectively a sunk cost.

[ Also refer to earlier articles on Relevant Costs ]

OPPORTUNITY COST

Represents the opportunities which have been forgone by following one course of action rather than an alternative course.

The opportunity cost in this case is the profit foregone by utilizing scarce resources for one particular course of action.

Illustration:

Company A may either manufacture or buy a component from an outside supplier.

If it buys from outside, the spare capacity can be rented out to another manufacturer for $20,000.

The opportunity cost of making the component would be to lose the opportunity to earn the $20,000

Note that the opportunity cost does not involve cash transaction but it is “relevant” to decision making.

INCREMENTAL OR DIFFERENTIAL COST

Incremental cost is used interchangeably with differential cost.

Incremental cost is the additional cost and revenue that may result from each degree of change in the level or nature of activity.

Whilst Differential cost is the difference in the cost and revenue between two alternatives.

Illustration:

Company A need to consider whether or not to accept a special order.

One relevant piece of information will be the variable cost.

The relevant cost before taking this special order is $25,000 and after taking the order it is $35,000.

Therefore the differential or incremental cost is $35,000-$25,000 which is $10,000

AVOIDABLE COST

Is cost that can be avoided if a given alternative is not adopted.

Illustration:

Assuming that a manufacturer decides not to proceed with a new product line which enable total savings in direct material, labor, direct expenses and variable costs of $10,000.

In this case, the differential cost of $10,000 can be avoided. The $10,000 is the avoidable cost.

RELEVANT COSTS

Management needs sufficient and relevant information make the correct decisions. Hence, the need to understand relevant costs.

A relevant cost relates to future expected costs that will differ with each alternative used.

Because of the difference amongst alternative, hence it has a bearing on the decision to be made.

Irrelevant costs simply are costs that will not affect the decision. By analyzing these type of irrelevant costs, management will be wasting their time and efforts as these costs do not affect the decision they are going to make.

FEATURES or CRITERIA of Relevant Costs:

• Relevant cost is a cost that will be incurred in the future. Historical costs are sunk costs which has no relevancy in the decision making.
• The costs must differ between alternatives. If a cost is the same whether we choose alternative A or B then this is an irrelevant cost. A good example is factory rental which remains the same irrespective of management wanting to manufacture product A or B.
• Only CASH flow item And Incremental fixed costs are relevant. Non cash item like depreciation and absorbed fixed overheads are not relevant costs as they do not involve any additional cash flow.

AREAS OF SHORT TERM DECISIONS WHERE RELEVANT COSTS ARE APPLIED:

•  Limiting factor due to scarce resources;
•  Make or Buy decision;
• Accept or Reject special order;
• To continue or discontinue or shut down decisions;
• Pricing