Accepting Special Order Pricing to use up Spare Capacity – Explanation with Solved Examples:
In the short term decision making, a business must ensure that revenue from each output item at least covers variable costs and yields a positive contribution towards covering the fixed costs. Once contribution covers the fixed costs then both profits and contribution increase with the same amount. When a business is working as its full capacity then increase in output requires a new element of fixed costs. On the other hand, if the business decides to work within the same capacity then the business should focus on those activities which generate the highest contribution.
If business is not working at its full capacity then how should it use its idle capacity or increase the volume of activity. One option could be to accept a request from a customer for a special price for a particular order. Customer may well know that business is not operating at full capacity and may therefore try to use their bargaining power to force a lower sale price. At first glance, it may appear that accepting an order at less than full cost only contribute a loss to the firm’s overall profitability, however this is not necessarily the case. Under certain conditions, special order less than full costs may, in fact, increase a firm’s overall profitability.
The business should accept the special orders if the sale price covers the variable costs and if there is an alternative use for spare capacity then this could result in a higher overall contribution. The idea is that when business is slack, any marginal contribution towards covering the fixed cost is better than not to have any contribution at all. So generally any special order which results in a positive contribution should be accepted.
Solved Example 1:
Hill View Hotel rents out a room at $50 per night, during tourists’ season, calculated on per night basis as follows:
During off season a tourist company has offered to hire 10 rooms @ $32 per night for 40 nights. Advise the management on financial grounds whether rooms should be rented out to the tourist company?
Calculation per night marginal cost
As marginal revenue of $32 from room hire is covering marginal costs and also contributing $4 ($32 – $28) towards profits so on financial grounds the offer from tourist company should be accepted.
Solved Example 2:
The Distinctive Hardware Industries manufactures one product toolboxes. Company is operating at 60% of its normal capacity. It sells the toolboxes at $10 each. An income statement for the year ended 30 June 2016 is as follows:
A major automobile company Deewan group, has offered to purchase 40000 toolboxes modified to their specifications. The tool boxes will differ significantly from usual design and the buyer will market the toolboxes under its own private label. Thus these tool boxes will not complete with Distinctive Hardware’s regular toolboxes.
The Deewan group has offered Distictive Hardware Industries $5.50 per toolbox. Direct labor and overheads will be at the same unit cost as Distinctive Hardware Industries’ regular toolboxes. Direct materials will amount to $1.50 per toolbox. Shipping costs to be borne by Distinctive Hardware will amount to 10 cents per tool box.
State on financial grounds should the special order be accepted?
Acceptance of Order with Negative Contribution:
- A special order that yields a negative contribution may be accepted under the following conditions:
- In order to retain a highly skilled and trained workforce.
- In order to keep plant in gear as the idle plant may become inefficient and lose its value more quickly than when being used, e.g., in hosiery industry.
- In order to excite further orders at high prices in the future.
- For charitable or sympathetic reasons.
Conditions for Accepting Order below Normal Price:
A list of circumstances which justify acceptance of order below normal price is given below:
- To manage the distress situation.
- To maintain production and to keep employees busy and occupied.
- To avoid loss of future orders, especially if business is operating in a highly competitive environment.
- To use spare production capacity in the business.
- To dispose of accumulated obsolete or perishable inventory.
- To improve the sale of a more profitable conjoined product.
- To promote or popularize a new product.
- The order is excepted to be followed by further orders.
Considerations for Accepting Order below Normal Price:
A business should manage its policy of accepting orders at a price below the market price in the following manner:
- The order must not displace other business revenue.
- The acceptance of the order is the most appropriate option to use the spare capacity.
- There must be clear distinction of existing customers from customers receiving the order priced below the normal selling price.
- Customer receiving goods must be aware that the price quoted is for that one order only so these prices should not be demanded for future orders.
Consequences of Accepting Order below Normal Price:
- Once an order is accepted at a price below the normal price then other customers may be influenced to ask for lower prices as well.
- Customer receiving goods may ask for the same reduced price for future orders.
- The spare capacity, which could be used for the future full price business, may be locked-up due to special order.
- The competitors may start following price cutting approach which may damage the whole industry.