9.7: Accept Business at Reduced Price
A manufacturer may receive an offer to produce and sell additional items, but at a selling price lower than normal. If the company has the capacity for the additional production, it may use differential analysis to determine if the order should be accepted or rejected based on financial considerations.
Spark Top Company manufactures countertop toaster ovens and sells them for $60 per unit. An overseas wholesaler offers to purchase 5,000 toaster ovens for $36 per unit, which would be additional production beyond what Spark Tophad planned for. The company has the capacity to process this special order. The variable manufacturing cost per unit is $25, and the fixed manufacturing cost per unit is $15. A tariff of $800 is charged to the company for shipping each batch of 5,000 toaster ovens.
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Accept |
Reject |
Difference |
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Revenue 1 |
$180,000 |
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Costs: |
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|
Production costs 2 |
125,000 |
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Tariff |
800 |
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Income (loss) |
$54,200 |
$54,200 |
1 $5,000 x $36
2 $5,000 x $25
No additional revenue or variable costs will be recognized if the company rejects the special order. If it is accepted, revenue will exceed variable costs. Fixed costs are not factored in since they will be incurred regardless of the decision. The company should accept the special order.
The implications of special order pricing may go beyond just financial considerations. For example, processing special orders may reduce demand for the same product at the normal selling price, ultimately decreasing overall income. In addition, regular customers may be irritated to learn that new customers are receiving a better deal and either demand a price match or consider shopping elsewhere.
As has been discussed and illustrated, differential analysis involves looking at the different benefits and costs that would arise from alternative solutions to a particular problem. Much of the analysis is quantitative, but it is also important to consider qualitative factors such as customer loyalty, vendor relationships, employee morale, social responsibility, and opportunity costs. The financial element, however, is a critical starting point for managerial decision making.