Every business survives on the profit it makes from selling its products and services. The business gets order and completes it to earn revenue. Generally, a business has a specified customer base that places order every month or time to time. Apart from this, the business gets special orders as well. These special orders mean that the business gets a specified order for a large quantity from a customer. These orders generally wish to have the products at a lower price. Thus, it is in the hands of the business whether to accept such order or reject it. The business has to take such a decision very carefully after the detailed analysis of all the aspects of the order.
Such orders are just one-time orders. These orders do not affect the regular sales of the business and these orders are accepted only if they are within the capacity of the business i.e. the idle capacity is being utilized. The business uses several methods to do the analysis of the different options available like comparing the income statements of both the methods. Comparison of profits made etc.
But there is a method which is widely used and is practically applicable. This method takes into consideration the increasing cost and the increasing revenue only. The components of this method are:
This method is used exclusively for the decision making that whether the asset be used or not. It is the most simplified and comprehensive way to state which method is to be used. It the straight forward method to determine the most appropriate method. This method can be studied as below:
A. Incremental Gain/ Revenue: Incremental revenue is the increase in the sales resulting due to the taking up of the order. If the order is accepted, it will result in the increase in the sales as the order so received is the order above the regular sale of the business. Thus, this revenue is the reward for the risk taken to accept the order.
B. Incremental Cost: Incremental Costs mean the increase in the costs due to the increase in the production. These costs are compared against the incremental revenue. These costs are generally the increase in the variable cost as the fixed costs remain the same. Only the variable costs increase and thus make the cost to increase and affect the profit.
The Incremental cost and revenue decide whether the order is to be accepted or not. The additional revenue and the cost are compared. If the net is a positive figure i.e. the revenues are higher than the costs, it should be accepted but if the net is a negative figure i.e. the costs are higher than the revenues, it should be rejected.
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The amounts which affect the costs or revenues in the process of special orders are relevant to the decision making. If the certain transaction has no effect on the special order making, then it will not be considered for the purpose of making interest. For example, the Fixed costs in a business are the fixed costs. They would not change even if the output of the firm is increased. The fixed costs increase only if the scale of operations is changed. But in case of special orders the scale remains the same. Therefore, the fixed costs do not play a decision determining role in accepting or rejecting the orders. But if the fixed costs fluctuate and make an effect on the cost, then it will also be considered for the making of the decision.
Thus, after complete analysis the decision about whether accepting or rejecting the order is made.
There can be three conditions:
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A limited receives an order of 10,000 units every month. Its Income statement was as below:
|Sales ( $5 p.u.)||50,000|
|Less: Variable Cost ($3 p.u.)||(30,000)|
|Less: Fixed Cost||(5,000)|
A limited receives a special order of 5,000 units at a reduced price of $4 p.u. For this purpose, the company does not need to make any changes. It will have to incur just the fixed expenses without compromising with it initial sales which will remain the same. Should A Limited take up the order?
The detailed analysis is done below:
|Less: Variable Cost ($3 p.u.)||(30,000)||(45000)|
|Less: Fixed Cost||(5,000)||(5,000)|
Thus, the accepting of the order will yield the business an extra income of $ 5,000. Thus the order can be accepted. This can be studied by the way of incremental cost and incremental revenue as below:
|Incremental Revenue ( $4 X 5,000)||20,000|
|Less: Incremental Cost ($3 X 5,000)||(15,000)|
Thus, we see how both the income statement and the incremental gain/ loss method works in the calculation and analysis that whether the order should be accepted or not.
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