Cost Accounting for Decision-making Lesson 5

Part III Different Types of Business Decisions (Accept or Reject an Order at a Special Price)

Five Types of Business Decisions Hire, make or buy Accept or reject an order at a special price Eliminate or retain an unprofitable segment Retain or replace equipment Sell or process further Teacher hightlights the second type of decision-making situation – Accept or reject an order at a special price.

Accept or Reject an Order at a Special Price A special order is a one-time customer order, often involving a large quantity with a low price. 2 points to note when making such decision - focus on relevant information (i.e. information related to those revenues and costs that will change if the management accepts the special order) - justify the choice using the contribution margin approach Teacher explains the meaning of a special order and reminds students the two important points in making this type of decision.

Accept or Reject an Order at a Special Price DECISION RULE If expected increase in revenues > expected increase in variable and fixed costs Accept the special order If expected increase in revenues < expected increase in variable and fixed costs Reject the special order Teacher explains the decision rule to accept or reject an order at a special price.

Example of Special Sales Order Assume that Company ABC’s milk plant is running at 90% of its monthly capacity. It has just received a special order to produce 40,000 boxes of milk for a new supermarket. Since the supermarket will sell the milk under its own private brand name, Company ABC has to spend extra $5,000 to design the label for that. If the supermarket has offered to pay $19 per box, which is well under Nestle’s normal order price, do you think Company ABC should accept or decline the special order? Teacher illustrates the meaning of a special sales order with an example.

Is there enough excess capacity to fill this order? Costs of Company ABC at current production level (450,000 boxes) are as follows: Total ($’000) Per box ($) Direct materials 4,500 10 Direct labour 1,350 3 Variable MOH 900 2 Fixed MOH 2,700 6 Total 9,450 21 Is there enough excess capacity to fill this order? 2. Will Nestle’s net profit increase or decrease if it accepts this special order? By how much?

Points to Note in Making the Decision How to calculate idle capacity? What are the relevant costs? If this special order is accepted, can profit be increased? Teacher explains some points that are relevant to make the decision.

Suggested Solution 1. Yes, there is enough capacity to fill the order. Full capacity = 450,000 / 90% = 500 000 boxes Excess capacity = (500 000 - 450 000) = 50 000 boxes The special order requires 40 000 boxes only 2. From (1), we can note that the company can fill the order without increasing its fixed costs. Therefore, the Company will not incur an additional $6 for fixed MOH for each box produced in this order. Teacher explains the solution.

The use of a marginal costing approach to determine whether the special order is profitable: Incremental Analysis (40,000 boxes) Total ($’000) Per box ($) Revenue 760 19 Variable costs (DM, DL, VMOH) (600) (15)* Contribution margin 160 4 Additional fixed cost (5) Increase in net profit 155 Teacher explains the solution and makes a conclusion. * The total variable costs per box: DM + DL + VMOH = $10 + $3 + $2 = $15 The total variable costs: $15 x 40,000 boxes = $600,000 Accept the special order as the company can increase the profit by $155,000.

Activity 1: Class Discussion What other factors the company should consider before making a final decision? Teacher invites students to share their ideas on qualitative factors for this special order decision.

Other Factors to be Considered Effect on the workforce Competitive considerations Prospects of future deals Effect on normal sales Teacher explains some possible qualitative factors for consideration in making decision on special order. Effect on the workforce – e.g. Will this special order help to avoid layoffs? Competitive considerations – e.g. Will this special order price start a price war with competitors? Prospects of future deals – e.g. Will this special order help to establish a long-term relationship between the company and the customer? Effect on normal sales – e.g. Will regular customers find out about this special order and ask for lower price?

Classwork The estimated sales of Jenny’s Ltd. is 50,000 cups at $4 per unit per annum. Variable manufacturing costs are at $1.5 per unit, and fixed manufacturing costs are at $0.8 per unit. A special order for 30,000 cups at $2.3 each is received by Jenny. It is known that the company has sufficient production capacity to accept this order without incurring any additional fixed manufacturing costs. However, the production would have to be done on an overtime basis at an additional cost of $0.2 per unit. Acceptance of the special order would not affect Jenny's normal sales and no extra selling expenses would be incurred. Teacher asks students to complete the classwork.

Required: Should this special order be accepted? What other qualitative factors the company should consider before making a final decision.

The use of a marginal costing approach to determine whether the special order is profitable: Incremental Analysis (30,000 unit) Total ($’000) Per unit ($) Revenue 69 2.3 Variable costs (45) (1.5) Contribution margin 24 0.8 Additional variable cost (6) (0.2) Increase in net profit 18 0.6 Teacher explains the solution and makes a conclusion. Accept the special order as the company can increase the profit by $18,000.

Qualitative Factors to be Considered Long term consequences of accepting the order below normal selling price (Normal price = $4; special price = $2.3) Other alternatives for the idle capacity Future business opportunities with this customer Effect on morale of workers being requested to work overtime Teacher makes comments and explains some possible qualitative factors that would affect the decision made on the special order.

Homework: Q6 Teacher asks students to do Question 6 at home.

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