One short-term decision that businesses continuously have to make is whether or not to accept special orders. This decision can prove somewhat of a complication to companies because they do not anticipate it when creating their yearly budget.
Although it might be outside an organization’s scope of activity, it can earn more revenue and crush sales goals. As the name implies, special orders are not the regular type of order.
They typically require a lower price than the regular orders, and your business might incur additional costs during the execution process.
Although special orders demand a lower price, the emphasis is much more on whether the order will result in a profit or not.
What is a special order?
A special order is a one-time customer order that often involves needing a large quantity at a low price. For most businesses, it’s a chance to make or lose money.
Tough choice, right?
When a special order is placed, you’ll be required to make decisions based on the analysis. And, of course, the goal is to make the best decision that will maximize profit.
To simplify things for you, here is a list of questions you should ask yourself when considering a special order;
What are the relevant costs?
Variable costs are the most relevant cost to the special order. Unlike fixed expenses, you want to make sure that your variable costs are covered.
For fixed costs, it would help to assume that you pay your fixed expenses from your regular production activities. It would help if you assumed that you received some orders, delivered the request, and billed the clients.
With this revenue, you can cover your fixed cost, like insurance premiums, building a lease payment, etc.
Does your company have an excess capacity to fulfill the order?
As we mentioned earlier, a special order is a random order. As such, it should only be considered if you have extra capacity to do work. You must make sure that your company has the excess ability to do the job without altering the standard production process.
Will there be profit in the order?
You need to know this: you can accept a lower sales price and be profitable with a special order. Since fixed costs have already been paid for with your regular production, they have become sunk costs.
As such, you shouldn’t bother about covering your fixed cost with your special order revenue.
When should a Special Order Price be accepted?
Like with every other form of business, the goal here is also to make a profit. Accept a special order price if it will give the company an additional profit.
Based on the above explanation, we can draw that the special order price is the price at which the company is willing to offer the special order. Employ diligent care and attention when determining this price.
This will help you can build a good customer relationship and secure a potential next order. The result is that you and your customers are happy. It’s a win on both sides!
To achieve this satisfaction, the company should accept a lower profit margin with a large quantity. When these two are combined, you can make an excellent profit.
To further determine if you should accept a special order or not, use the contribution margin approach to do your analysis. This analysis will ascertain if the order will lead to a profit or loss. Follow these steps;
1. Determine the contribution margin per unit
The formula for calculating the contribution margin per unit is:
Order Price – Variable Costs per unit.
Exclude irrelevant costs like fixed costs from the calculation.
2. Determine the total Contribution Margin
You can determine this by multiplying the contribution margin per unit by the number of units in the special order.
3. To determine Profit or Loss, less any Incremental Fixed Costs from the Contribution Margin
If there are any incremental fixed costs, you’ll have to subtract them from the contribution margin. But if there are no fixed costs, your contribution margin is your total profit. It’s that simple.
4. Decide whether or not to accept the Job
The general rule is to take the job if it generates a profit and decline if it incurs a loss.
Bottom Line
You will agree that the entire concept of special order pricing is not as difficult as it seems. It starts by identifying your irrelevant costs and subtracting them from your calculations.
Use the answer you derive from the contribution margin approach to determine if you should accept or reject the order.
