This lesson examines special order decisions, which involve evaluating a one-time order that is not part of normal business operations. It covers the application of relevant costing to determine whether to accept or reject a special order, considering capacity constraints.

• Definition and Purpose: A special order is a one-time order that is not connected to an organisation’s normal business. Special orders do not affect normally projected sales. Requests for charity or non-profit events are examples of special orders. Differential decision-making can be used to analyse the effects of accepting a special order.

• The Relevant Cost Analysis:

  • Relevant Costs: The incremental costs of producing the special order are relevant. This includes direct materials, direct labour, and any variable overhead that will be incurred. If the special order requires additional fixed costs (e.g., overtime premiums, set-up costs), these are also relevant.

  • Irrelevant Costs: Fixed costs that are already being incurred and will not change are irrelevant. Sunk costs are also irrelevant. If the company has idle capacity, the fixed costs associated with that capacity are not relevant to the decision.

  • The Decision Rule: A special order should be accepted if the incremental revenue from the order exceeds the incremental costs. The special order price should cover all incremental costs. If the order is accepted, it should not affect regular sales.

• Example: A company with excess capacity receives a special order for 2,400 units at a price of $10 per unit. If the variable cost per unit is $9.50 and there are no additional fixed costs, the incremental profit is $0.50 per unit, and the order should be accepted. If the special order price is below the incremental cost, it should be rejected.

• Capacity Constraints: If the company is operating at full capacity, accepting a special order would require sacrificing regular sales. In this case, the opportunity cost of lost regular sales must be included as a relevant cost. The special order is only acceptable if the incremental revenue exceeds the incremental costs plus the opportunity cost.