 Hello and welcome to the session. This is Professor Farhad in the session. We're going to look at special order or pricing special order This topic is covered in a managerial accounting as well as cost accounting It's covered on the CMA exam the CPA exam as well the BEC section additional similar Lectures as well as example additional examples can be found on my website farhadlectures.com where I will also post the lectures for this The PowerPoint slides for this lecture. So what is a one-time special order? Well, it's not unusual for a manufacturers to be approached by a third party To ask them to produce something for them Maybe similar to what we are currently producing maybe a little bit different. It may require some special Some additional features or may not so should we accept the order? That's the question here So it's a one-time special order is a good. Is it a good deal? Should should the manufacturers accept that one special order? Well, the first thing we have to ask ourselves Do we have the capacity the first thing is we ask ourselves do we have to have the capacity? Otherwise, if we don't have the capacity that we have idle production capacity For example, that capacity could be machine hours a direct label hours where they're not being used if the answer is Yes, we will proceed and find out if it's a good deal and at what price we need to charge this customer So those are the first thing we need to determine Accepting or rejecting when there is an idle production. Obviously, we need to have the idle production. Okay Also, the decision rule is this is this order is going to increase our operating income So it with our operating income goes up. Okay in here. We are talking from strictly quantity quantifiable Analysis so from a number revenues minus additional revenues minus additional Cost is this going to be a positive or negative and the answer is if the if it's positive We accept if it's negative we reject now bear in mind bear in mind that we do have Non-quantifiable factors, so we have to be careful for qualitative factor. What could be some qualitative factor? Well Non-quantitative or qualitative factor of whatever you want to call them Such as what is my the effect on my existing market share? Remember, I'm gonna be producing something similar to what I'm currently producing whatever I'm producing I'm gonna be using shoes. I'm producing shoes and that third party or the other parties asking me to also produce shoes So they might be competing with me. So I have to be careful about how is that gonna affect my market share What is the effect on my employee morale? I'm overworking my employee What's gonna be the morale on that logistical consideration is this Do I have to ship the product not ship the product so on and so forth the quality requirement? What what are they asking me to produce because more or less my name will go on that product So what if the quality is not good that they're asking? What's my reputation? So those are non-qualitative Quantitative which are quality the factor which we don't really you know This is it's case-by-case situation. Okay, but simply put what's gonna be important for us is Relevant revenues and relevant cost. So they determine the profitability of this project. We have to determine. What is our relevant? Revenue and relevant cost. Okay, so let's review. What is relevant versus irrelevant? What's relevant revenue or Relevant cost. It's a cost or revenue that differ between alternatives. So if we did take the if the if we did take this Project, what is the difference in cost and what's the difference in revenue? That's relevant cost and relevant revenue It's gonna make a difference to our cost make a difference to our revenue that item is relevant Obviously irrelevant is something that will be incurred regardless if we make the product or not So if we accept the special order or not Irrelevant cost they're gonna be incurred they're called also some cost basically there's nothing we can do about them They already exist now. We have to be careful Lot of people think that all variable cost are relevant and the and the most variable cost are relevant not all Okay, so not every time you see variable cost you would say it's relevant Variable cost means it's a cost that varies with your production. That's gonna change with your production Obviously if you are producing more of something you will incur that cost generally speaking We're talking about direct material and direct labor and variable overhead. Usually those are Relevant cost because if you need to produce something you need to input material labor and variable overhead Therefore it will but not all and we'll see an example What what do I mean not all at the same time most fixed costs are irrelevant? I didn't say all I would say most So as long as you are not told otherwise as long as you are not told otherwise then Fixed cost is considered irrelevant because it's going to be incurred Regardless, whether we take this project or not So the first thing to determine if we if we need to accept or reject an order is do we have the idle capacity? So let's take a look at an example to illustrate this point Let's assume we are manufacturing shoes and this is the shoes that we are manufacturing We're selling each shoe for $20 our direct material is $6 per pair per pair Direct labor $4 per pair variable overhead $2 per pair variable selling cost $1 per pair and fixed cost is $3 per pair our total cost is $16. So this is what we have right now Okay, and we manufacture those those shoes and 100 batches pairs So every time we set up the batch we can produce 100 pairs each batch consume five hours to be manufactured So every time we need to produce 100 pairs, which is a batch we consume five hours of machine time The plant has a capacity of 4,000 machine hours Currently the production consumes 80% of capacity simply put we have 4,000 Hours we are consuming 80% 80% is 32 This means we have 20% that's idle production capacity or equivalent to 800 hours So here's what happened at this count store approached us and asked us to produce 10,000 pair of shoes well the first thing we have to ask ourselves Do we have the capacity to produce the 10,000 10,000 pairs of shoes before we even accept? We have to ask ourselves. Do we have the capacity? Let's see if we have the capacity Now 10,000 pairs of 10,000 pairs we can produce them in 100 pairs Batches that's gonna that's gonna keep us with 100 batches times five hour per batch We need 500 hours. We have 800 so we have plenty of time To produce those shoes. So there is no opportunity cost here because we don't have to develop any of our production So here's what that this counter want us to do They request the shoes to be its own private label because obviously They're selling it in their own stores. I want to put their name on it to add the label to add the label It's gonna cost us an additional half a dollar or 50 pennies per pair And no variable price is incurred here. So notice here There's the variable selling and here we in other words We did not have to our sales people that not have to incur any effort for this order So this order came to us. Therefore, we are not paying someone a dollar for every pair of shoes They sell therefore variable cost here is irrelevant. Why because we are told that's irrelevant That's what we're saying here. So the question is should we accept Disorder or at least how much what's the minimum because we are not told what's what they're offering us as a price The question is what's the minimum? You might be asked. What's the minimum you would accept for this order? Okay, so let's see. How do we determine? What's the minimum? Well, we have to figure out what costs are we gonna be incurring? Do we have to incur direct material? Sure, we have to incur six dollars of direct material Do we have to incur direct labor? Of course, we do we have to incur four dollar Do we have to incur variable overhead cost? Sure, we do two dollars. So those are what's considered relevant Relevant What about variable selling? No variable selling. Why because we are told this company approached us our sales people did not make any effort We're not gonna pay them a dollar Fixed cost as long as we are not told anything about fixed cost. We assume the fixed cost is irrelevant Therefore, that's that but we have to be careful for this order. We have to add 50 pennies. Why? because because They need to add their own private Label which is gonna cost us 50 pennies. So if we add the order we have to add our cost our cost is $12 and 50 cent So simply put simply put what what price we should charge in theory any price above 1250 should be good for us in Theory now bear in mind for example, if they're offering us maybe $12 and 55 cent We might say, you know, there's a reasonable test We have to go through but simply put anything above 1250 is acceptable because our operating income Should increase by whatever pennies times the units. Okay So let's look at another example. That's a little bit more involved. Okay Uh profitability of order and opportunity cost Dawson company produces and sells 80 000 boxes of specialty food each year So they sell 80 000 each box contain the same sort amount of food The company has computed the following annual cost. And this is what we have variable production cost 400 000 fixed production cost 480 variable selling 320 fixed selling and administrative 200 000 total cost 1.4 million The company charges 25 per box a new distributor has offered to purchase 8 000 box at a price of 22 per box We usually sell them for 25. We have a special order to to sell them for 22 Dawson will incur an additional one dollar packaging cost or so one dollar packaging cost per box to complete this order So it's going to cost us an additional Suppose Dawson has surplus capacity To produce the 8 000 boxes what we are told here is don't worry about the capacity We have plenty of capacity. So the first thing we're going to illustrate We have the capacity to produce those 8 000 boxes will be the effect on Dawson income if it accept this order Well, if we accept this order simply put we have to determine what is our incremental profit or our additional contribution margin The best way to do so is to just I would say prepare an income statement But again, there is more than one way to do this But let's go ahead and look at an income statement assuming we're going to be selling 8 000 let's just Go through here. We're going to sell 8 000 additional unit times 22 dollars So let's go ahead and Start with our sales 8 000 times 22 dollars our sales is 176 000 Are we going to be incurring variable production cost? Of course, of course, we are so what is our variable production cost? Well If we are incurring 400 000 And we are producing 80 000 unit 400 000 divided by 80 000 unit Our variable cost is five dollar per unit. So it's 8 000 unit times five dollar variable cost That's going to give us our variable cost of 40 000 dollar And obviously that's going to be subtracted from the revenue Um variable selling. We are not told it's going to be eliminated. So we're going to have to keep variable selling 320 divided by 80 000 unit That should be four dollar per unit. So variable selling is 8 000 unit times four dollars and that's 32 000 dollar and variable selling it's going to be minus and remember we have a packaging cost and that's easy because it's one dollar per box an additional dollar So that's 8 000 dollar Now let's take a look what we have 176 of revenues minus 40 000 of production cost minus 32 000 of variable selling minus 8 000 8 000 of packaging we have an additional contribution margin of 96 000 Should we accept the order and the answer of course we should why not? It's going to increase our contribution margin by 96 000 dollar Okay Now let's look at b. b supposed that instead of having surplus capacity to produce 8 000 more boxes Dawson has surplus capacity to produce Only 3 000 boxes. What will be the effect on Dawson's income if it except the new order? So what we are saying here is we have capacity, but we only have the capacity to produce 3 000 unit. What happened if we accept The 8 000 unit. Well, we if if we accept the 8 000 unit we have to give up 5 000 units We have to give up 5 000 unit. Why? Because We have to give up 5 000 unit because to produce to to fill out this the special order We can only fill out 3 000 therefore. We have to give up 5 000 from our own unit Should we should we should we go ahead? Okay. Well, we have to determine. What is our opportunity cost? What if we gave up those 5 000 unit? How much are we given up? Okay, so let's again. Let's work kind of an income statement Foregone basically Here's what's going to happen lost revenue. What happened if we accept this? We're going to have 5 000 unit of lost revenue times 25 dollars and that's 125 000 of lost revenue well Yes, we did lose revenue, but also we're going to be eliminating some variable cost Well, as we determine variable production cost is five dollar per unit. So that's 5000 times five we're going to save Variable cost saved here 25 000 Also, we're going to be there is a variable Selling cost save remember it's four dollar computed here 5 000 times four dollars that's going to be 20 000 Okay, so now if we take Revenue law revenue lost and we net it from the from the from the Cost saved we're going to have Revenue loss of 80 000 revenue or contribution margin loss additional contribution margin loss of 80 80 000 Should we accept? Well, let's let's let's think about it if we accept We're going to bring our contribution margin up by 96 000 as we as we as we computed here But we're going to give up 80 000. So overall we are still up 16 000. So based on quantitative factor, we should accept this order of 16 of Of this unit because we did We will be positive in other words. It will be a positive 16 000 overall This is basically an example of special order I will work maybe a few cpa questions or few multiple choice questions just to consolidate this point If you have any questions any comments By all means email me But if you're studying for your cpa or your cma exam, make sure you are comfortable with this topic. Good luck