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The decision to accept/reject a special order - 2

In the example that follows, we will produce:

  1. Budgeted income statement (without the special order);
  2. Total income statement (including the special order);
  3. Income statement (showing incremental income and costs for a special order).

Example

The Jolly Inc. company is considering whether it should accept a special order for 15,000 units from a customer in Malaysia who has offered an ex-factory cost of £48.00 per unit. The overseas customer will pay all delivery and insurance costs, and revenues will be restricted to its own country. In this example, we will assume that the company does not sell any units in Malaysia. The following data relates to the volumes, prices and costs for the year.

Production capacity80,000 units
Forecast revenues volume60,000 units
Selling price£72.00
Materials5kg at £3.00 per kg
Labour2 hours at £9.00 per hour
Variable overheads£1.50 per labour hour
Fixed production overheads£420,000
Selling costs£360,000
Administration overheads£500,000

Table 1 Budgeted income statement

Forecast revenues volumne: 60,000 units

    £ £
Revenues (60,000 x £72.00)   4,320,000
Direct materials (60,000 x 5kg x £3.00) 900,000  
Direct Labour (60,000 x 2hrs x £9.00) 1,080,000  
Variable Overhead (60,000 x 2hre x £1.50) 180,000  
Fixed overhead   420,000  
Total production costs     2,580,000
= Gross margin     1,740,000
Selling costs     360,000
      1,380,000
Administration costs     500,000
=Net profit     880,000

From the above statement it can be seen that the Jolly Inc. company is budgeting to make a profit of £880,000 for the year. It has used 60,000 units and has spare capacity of 20,000 units this year. Calculations are show where required. Fixed overheads, selling costs and administration costs are all considered fixed costs.

Table 2 Total income statement including special order

Expected revenue volumne: 75,000 units

    £ £
Budgeted revenues (60,000 x £72.00)   4,320,000
Revenues from special order (15,000 x £48.00)   720,000
Total revenues     5,040,000
Direct materials (75,000 x 5kg x £3.00) 1,125,000  
Direct Labour (75,000 x 2hrs x £9.00) 1,350,000  
Variable Overhead (75,000 x 2hrs x £1.50) 225,000  
Fixed overhead   420,000  
Total production costs     3,120,000
= Gross margin     1,920,000
Selling costs     360,000
      1,560,000
Administration costs     500,000
=Net profit     1,060,000

In Table 2, the effect of the additional volume can be seen. We have added in the incremental revenues of 15,000 units that increases total revenues to £5,040,000. We have also increased the total volume for materials, labour and variable overheads to 75,000 units and kept fixed production overheads, selling costs and administration costs at their budgeted level. Should there be additional costs associated with the special order, these would have to be included.

A comparison of Table 1and 2 shows that the net profit figure would increase from £880,000 to £1,060,000 if the special order was accepted. From a financial point of view the special order should be accepted. However, this might only be beneficial in the short-term; if volume was expected to expand within the existing customer base the company would not be able to obtain its expected market share. In general, special orders should be short-term, accepted to fill a capacity gap and contribute additional profit to the company, i.e. incremental revenue exceeds incremental costs.

We now show an Income statement that highlights incremental revenue and costs. This statement, shown in Table 3, has been prepared to show an alternative method of analysis. By taking the Budgeted income statement in Table 1, plus the Income statement shown below, we obtain the same final result as Table 2.

Table 3 Income statement showing incremental income and costs for special order

Special order for 15,000 units

    £ £
Revenues (15,000 x £48.00)   720,000
Direct materials (5,000 x 5kg x £3.00) 225,000  
Direct Labour (15,000 x 2hrs x £9.00) 270,000  
Variable Overhead (15,000 x 2hrs x £1.50) 45,000  
Total production costs     540,000
= Gross margin     1,920,000

In the differential, or incremental statement shown above, the total production costs of £540,000 is deducted from the revenue of £720,000 to give a gross margin of £180,000. Here we can see that fixed production overheads are not included, since they have been ‘recovered’ from our existing budgeted activity. Similarly, selling costs are not included since it is unlikely that additional selling costs could be attributed to the special order. The same applies to the administration costs, the assumption being that there is sufficient capacity to deal with the special order, i.e. no direct costs should be incurred.

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