Tag: Modern Marketing Bangalore University BBA Notes

The term “value-added” describes the economic enhancement a company gives its products or services before offering them to customers. Value-added helps explain why companies are able to sell their goods or services for more than they cost to produce. Adding value to products and services is very important as it provides consumers with an incentive to make purchases, thus increasing a company’s revenue and bottom line.

Value-added could thus apply to instances when a firm takes a product that may be considered homogeneous with few differences from that of a competitor, if any and provides potential customers with a feature or add-on that gives it a greater perception of value. Adding a brand name to a generic product can be just as valuable as producing something new or in a way that no one has thought of before.

Value addition and Supply Chain

• Supply Chain basically starts from raw material suppliers, OEM, Distributor, Retailer and ends at Customer (or the other way around)
• Value can be roughly formulated as (Quality/Cost)

Value Addition in Supply Chain Management is about processes and activities that enables products (goods or services) to be more desirable by the customer  it has nothing to do with price or cost of production.

When you undergo a through analysis of supply chain systems (processes and activities) and you identify those that are not directly linked to ensure customer satisfaction and you remove such from the system, you are doing Value Addition.

Value-added is the difference between the price of a product or service and the cost of producing it. The price is determined by what customers are willing to pay based on their perceived value. Value is added or created in different ways.

These may include, for instance, extra or special features added by a company or producer to increase the value of a product or service. The addition of value can thus increase either the product’s price that consumers are willing to pay. For example, offering a year of free tech support on a new computer would be a value-added feature. Individuals can also add value to services they perform, such as bringing advanced skills into the workforce.

Consumers now have access to a whole range of products and services when they want them. As a result, companies constantly struggle to find competitive advantages over each other. Discovering what customers truly value is crucial for what the company produces, packages, markets, and how it delivers its products.

Bose Corporation, as an example, has successfully shifted its focus from producing speakers to delivering a “sound experience,” or when a BMW car rolls off the assembly line, it sells for a much higher premium over the cost of production because of its reputation for stellar performance, German engineering, and quality parts. Here, the additional advantage has been created through each brand’s symbolic value and years of refinement.

The purpose of supply chains is to add value to production and distribution. Depending upon the markets and the value chains they are servicing, supply chains can be differentiated according to criteria such as costs, time reliability, and risk. Efficient logistics contributes to added-value in four major interrelated ways:

Location. Logistics adds value by taking better advantage of various locations, implying access to expanded markets (more customers), and lower distribution costs.

Production costs. Derived from the improved efficiency of manufacturing with appropriate shipment size, packaging, and inventory levels. Thus, logistics contributes to the reduction of production costs by streamlining the supply chain.

Control. Added value derived from controlling most, if not all, the stages along the supply chain, from production to distribution. By better synchronizing cycles and lead times, logistics enables better marketing and demand response, thus anticipating flows and allocating distribution resources accordingly.

Time. Added value derived from having goods and services available when required along the supply chain (e.g. lower lead times) with better inventory and transportation management.

A variety of factors are jointly shaping the configuration of supply chains:

Transit time. A factor that is increasingly being considered since it strongly influences inventory carrying costs and inventory cycle time in supply chain management. So, for cargo with a higher value (clothing) or is perishable (refers), the routing option that is the fastest and/or shortest will be preferred.

Logistics costs. Considers the full array of costs to make products available to the final consumer, namely transport, warehousing, and transshipment. Supply chain managers are particularly sensitive to the stability of the cost structure (consistent costs), implying that routes having cost fluctuations may be discarded in favor of routes of a higher cost but with less volatility. Therefore, costs are a standard criterion where the cheapest routing option is sought, as long as the cost structure remains stable as supply chains are unlikely to be modified if a cost advantage is only temporary. The concept of cost is relative since its importance is concerning the value of the cargo being carried. Cost considerations tend to concern more containerized goods with a low value, such as commodities (e.g. paper), than high-value goods (e.g. electronics).

Supply chain risk. Relates to a generally imponderable factor and involving the level of confidence that the shipment will reach its final destination within expected costs, time, and reliability considerations. In some cases, risk can also involve potential cargo damage or theft. Low risks routes are obviously preferred over higher-risk routes.

Reliability. Relates to a factor that is mitigated by contemporary supply chain management practices. For several supply chains, time can be a secondary factor as long as shipments arrive at the distribution center within an expected time frame. If shipments are regular and that this reliability remains consistent, it is possible to organize supply chains accordingly by having more inventory in transit.

Plant or Factory Wide (Single) Overhead Absorption Rate

Plant or factory wide (single or blanket) rate is used for the whole factory and is assigned to all cost units irrespective of the departments in which they were produced.

Plant-wide overhead absorption rate = (Estimated FOH for the whole factory/ Estimated activity level for the whole factory) *100

Conditions for using plant wide overhead absorption rate:

• All production departments contribute in equal proportion to the fabrication of every product.
• Company produces only one type of product.

The above conditions restrict its usefulness and in the absence of above conditions. This does not produce satisfactory results.

Departmental Overhead Absorption Rate:

In case of departmental overhead absorption rate, separate overhead absorption rates are used for different producing departments. Though use of departmental overhead absorption rate is considered better than using a single (factory wide) overhead absorption rate but it has certain pros and cons which are given below:

Advantages:

• Per unit and total costs of a product can be more accurately.
• Use of separate rates for different departments facilities better control, as the departmental managers being responsible for costs of their respective departments have a closer look on overheads incurred.

Disadvantages:

• The departmental managers often do not have a significant role in the apportionment of overheads.
• This basis used for apportionment of overheads to different departments may not be fair or correct as overheads may not be incurred for the departments in the same way as shown by basis for apportionment.

Actual Cost

Actual cost is the actual expenditure made to acquire an asset, which includes the supplier-invoiced expense, plus the costs to deliver, set up, and test the asset. This is the cost of an asset when it is initially recorded in the financial statements as a fixed asset.

The actual cost approach is different from the use of estimates to derive costs that may occur in the future. The two approaches are commonly blended together, so that budgeted costs derived in advance are compared to actual costs to create a variance. The variance can be used to control operations and/or to work on improving the accuracy of predictions.

Well keep in mind in managerial accounting, you also have budgeted and forecasted costs. Neither of these costs reflects reality or actual costs most of the time. Management might set a budget to buy a new piece of equipment, but this budget does not always happen. Sometimes companies can get discounts from vendors and other times product prices increase.

Actual Cost = Direct Costs + Indirect Costs + Fixed Costs + Variable Costs + Sunken Costs

Direct Costs: Obvious costs directly related to your projects like fixed costs and variable costs.

Indirect Costs: Additional cost that supports your project but is not easily measured like administrative services.

Fixed Costs: Costs that remain consistently the same throughout the project, such as cost to rent equipment.

Variable Costs: Changing costs during the course of the project. An example the hours of anticipated labor for a project might be greater than the actual time it took for labor to be complete.

Sunken Costs: These are costs that have incurred due to an error or change of scope that must be included in the total cost of the project.

Normal costs

Normal costing uses a predetermined annual overhead rate to assign manufacturing overhead to products. In other words, the overhead rate under normal costing is based on the expected overhead costs for the entire accounting year and the expected production volume for the entire year.

Normal costing uses actual direct materials and direct labor costs, but adds budgeted factory overhead to track manufacturing costs. The budgeted factory overhead is calculated using your indirect costs and production estimates. Estimates are based on actual indirect costs and units produced from prior manufacturing runs. Since indirect costs like utilities, rent and depreciation remain fixed over time, normal costing can be used as a benchmark to monitor production costs.

It is a general rule that in the calculation of actual overhead rate, actual overheads will be divided with the actual quantity and not with the budgeted quantity. The vice versa also applies. The reason for this rule is simple as this provides more authentic results as you are comparing the like terms. However, contradictory as the may sounds, these rules do not apply in normal costing as in this method, the budgeted manufacturing overhead rate is multiplied with the actual quantity to derive the actual overhead costs. The reason for this is that it provides for the more authentic allocation base, and the overheads are allocated properly this way.

The overhead rate is the only figure that is budgeted in this method. To determine the material and labor costs, the actual figures are used. The same goes with the quantity of allocation.

Normal costing is used to derive the cost of a product. This approach applies actual direct costs to a product, as well as a standard overhead rate. It includes the following components:

• Actual cost of labor
• Actual cost of materials
• A standard overhead rate that is applied using the product’s actual usage of whatever allocation base is being used.

There are three methods for allocating service department costs: direct, sequential, and reciprocal. The first step of each method is to classify each organizational unit as either an operating or service department. Operating departments directly produce or distribute the company’s output, such as machining and assembly departments. Service departments provide services and support to operating departments as well as other support departments. Examples include human resources and information systems departments.

The problem in allocating service department costs is complicated by multiple-department relationships, where each service department may provide service to all of the other departments, including other service departments and itself. The three-service cost-allocation methods vary in terms of ease and accuracy because of how they approach this problem.

Production cost centers are directly involved in the production process as changing the shape of the material on worked upon, or just assembling the parts into a finished product. Typical examples of producing departments include cutting, stitching, spinning, assembly, weaving or etc.

Service cost centers refer to those costs that produce nothing but indirectly help in production by providing services to production cost centers. In certain cases service departments render services not only to the producing departments but also to other service departments. Typical examples of service departments include maintenance, stores, canteen, personnel, etc.

The direct method allocates costs to the operating departments directly, with no allocations to the other service departments. The method is easy to implement, but it ignores the fact that other service departments require services from each other, so it’s less accurate.

The sequential method (also known as the step-down method), allocates costs to operating departments and other service departments sequentially, but only in one direction. There is no set order in the sequence used: One common technique is to begin with the service department that incurs the most costs supporting other service departments and work downward to the department with the least costs. Once a service department’s cost is allocated out, however, no portion of its cost is allocated back to it from other service departments. This method partially recognizes other service departments, which makes it more accurate than the direct method.

The reciprocal method fully recognizes the other service departments by allowing reallocations back to each service department. As such, it’s more difficult to calculate but also more accurate than the other methods.

An algebraic method sometimes called the reciprocal method. This method allocates cost by explicitly including the mutual services rendered among all departments, causes of under and over absorption of overhead.

Procedure in Cost Allocation:

As products are not processed in service departments, their costs cannot be charged directly to products or cost units. Firstly, cost of service departments is built up by the usual process of allocation and primary apportionment. Afterwards their costs are allotted to production cost centers on some equitable or fair basis according to the use which producing departments make of service departments. Lastly, after calculating overhead absorption rates, costs of producing departments (including their share in the costs of service departments) are charged to jobs or products.

GAAP vs IFRS is the most debatable topic in accounting where the former is defined as the financial reporting method having universal applicability while the latter are the set of guidelines made for financial accounting. As an account professional or business owner, it is vital to know the variations of these accounting methods, in order to successfully manage your company globally, as well as domestically.

The IFRS vs US GAAP refers to two accounting standards and principles adhered to by countries in the world in relation to financial reporting. More than 110 countries follow the International Financial Reporting Standards (IFRS), which encourages uniformity in preparing financial statements.

On the other hand, the Generally Accepted Accounting Principles (GAAP) are created by the Financial Accounting Standards Board to guide public companies in the United States when compiling their annual financial statements.

GAAP

The GAAP is a set of principles that companies in the United States must follow when preparing their annual financial statements. The measures take an authoritative approach to the accounting process so that there will be minimal or no inconsistency in the financial statements submitted by public companies to the US Securities and Exchange Commission (SEC). It enables investors to make cross-comparisons of financial statements of various publicly-traded companies in order to make an educated decision regarding investments.

IFRS

The IFRS is a set of standards developed by the International Accounting Standards Board (IASB). The IFRS governs how companies around the world prepare their financial statements. Unlike the GAAP, the IFRS does not dictate exactly how the financial statements should be prepared but only provides guidelines that harmonize the standards and make the accounting process uniform across the world.

Both individual and corporate investors can analyze a company’s financial statements and make an informed decision on whether or not to invest in the company. The IFRS is used in the European Union, South America, and some parts of Asia and Africa.

Differences between IFRS and GAAP accounting:

Methodology

GAAP focuses on research and is rule-based, whereas IFRS looks at the overall patterns and is based on principle.

Adoption

IFRS is a globally adopted method for accounting, while GAAP is exclusively used within the United States.

Developed by

The principles of IFRS are issued by the International Accounting Standard Board (IASB), while GAAP are issued by Financial Accounting Standard Board (FASB)

Inventory Reversal

IFRS and GAAP accounting also differ when it comes to inventory write-down reversals. In GAAP, the amount of the write-down cannot be reversed. However, under IFRS, the amount of the write-down can be reversed.

Inventory Methods

GAAP uses the Last In, First Out (LIFO) method for inventory estimates. However, in IFRS, the LIFO method for inventory is not allowed.

Income Statements

Extraordinary or unusual items are included in the income statement and not segregated under IFRS. While, under GAAP, they are separated and shown below the net income portion of the income statement.

Fixed Assets

In fixed assets, companies using GAAP accounting must value these assets using the cost model. IFRS uses a different model for fixed assets called the revaluation model.

Intangible Assets

When it comes to intangible assets, IFRS takes into account whether an asset will have a future economic benefit as a way of assessing the value. Intangible assets measured under GAAP are recognized at the fair market value and nothing more.

Quality Characteristics

Finally, the qualitative characteristics to how the accounting methods function. GAAP works within a hierarchy of characteristics, such as relevance, reliability, comparability and understandability, to make informed decisions based on user-specific circumstances. IFRS also works with the same characteristics, but with the exception that decisions cannot be made on the specific circumstances of an individual.

Development Costs

Development costs can be capitalized under IFRS, as long as certain criteria are met. With GAAP, development costs are not allowed to be capitalized.

The equity method is a type of accounting used for intercorporate investments. It is used when the investor holds significant influence over the investee but does not exercise full control over it, as in the relationship between a parent company and its subsidiary. In this case, the terminology of “parent” and “subsidiary” are not used, unlike in the consolidation method where the investor exerts full control over its investee. Instead, in instances where it’s appropriate to use the equity method of accounting, the investee is often referred to as an “associate” or “affiliate”.

There are several types of equity accounts that combine to make up total shareholders’ equity. These accounts include common stock, preferred stock, contributed surplus, additional paid-in capital, retained earnings, other comprehensive earnings, and treasury stock.

Equity is the amount funded by the owners or shareholders of a company for the initial start-up and continuous operation of a business. Total equity also represents the residual value left in assets after all liabilities have been paid off, and is recorded on the company’s balance sheet.

Types of Equity Accounts

Preferred Stock

Preferred stock is quite similar to common stock. The preferred stock is a type of share that often has no voting rights, but is guaranteed a cumulative dividend. If the dividend is not paid in one year, then it will accumulate until paid off.

Common Stock

Common stock represents the owners’ or shareholder’s investment in the business as a capital contribution. This account represents the shares that entitle the shareowners to vote and their residual claim on the company’s assets. The value of common stock is equal to the par value of the shares times the number of shares outstanding.

Contributed Surplus

Contributed Surplus represents any amount paid over the par value paid by investors for stocks purchases that have a par value. This account also holds different types of gains and losses resulting in the sale of shares or other complex financial instruments.

Retained Earnings

Retained Earnings is the portion of net income that is not paid out as dividends to shareholders. It is instead retained for reinvesting in the business or to pay off future obligations.

Additional Paid-In Capital

Additional Paid-In Capital is another term for contributed surplus, the same as described above.

The following formula and calculation can be used to determine the equity of a firm, which is derived from the accounting equation:

Shareholders’ Equity = Total Assets – Total Liabilities

This information can be found on the balance sheet, where these four steps should be followed:

• Locate total liabilities, which should be listed separately on the balance sheet.
• Locate the company’s total assets on the balance sheet for the period.
• Note that total assets will equal the sum of liabilities and total equity.
• Subtract total liabilities from total assets to arrive at shareholder equity.

Components of Shareholder Equity

Retained earnings are part of shareholder equity and are the percentage of net earnings that were not paid to shareholders as dividends. Think of retained earnings as savings since it represents a cumulative total of profits that have been saved and put aside or retained for future use. Retained earnings grow larger over time as the company continues to reinvest a portion of its income.

At some point, the amount of accumulated retained earnings can exceed the amount of equity capital contributed by stockholders. Retained earnings are usually the largest component of stockholders’ equity for companies that have been operating for many years.

Treasury shares or stock represent stock that the company has bought back from existing shareholders. Companies may do a repurchase when management cannot deploy all the available equity capital in ways that might deliver the best returns. Shares bought back by companies become treasury shares, and their dollar value is noted in an account called treasury stock, a contra account to the accounts of investor capital and retained earnings. Companies can reissue treasury shares back to stockholders when companies need to raise money.

Common variations on equity:

• On a company’s balance sheet, the amount of the funds contributed by the owners or shareholders plus the retained earnings (or losses). One may also call this stockholders’ equity or shareholders’ equity.
• A stock or any other security representing an ownership interest in a company.
• In margin trading, the value of securities in a margin account minus what the account holder borrowed from the brokerage.
• When a business goes bankrupt and has to liquidate, equity is the amount of money remaining after the business repays its creditors. This is most often called “ownership equity,” also known as risk capital or “liable capital.”
• In real estate, the difference between the property’s current fair market value and the amount the owner still owes on the mortgage. It is the amount that the owner would receive after selling a property and paying any liens. Also referred to as “real property value.”

Integrated reporting in corporate communication is a “process that results in communication, most visibly a periodic “integrated report”, about value creation over time. An integrated report is a concise communication about how an organization’s strategy, governance, performance and prospects lead to the creation of value over the short, medium and long term”.

Integrated Reporting brings together material information about an organisation’s strategy, governance, performance and prospects in a way that reflects the commercial, social and environmental context within which it operates. It leads to a clear and concise articulation of your value creation story which is useful and relevant to all stakeholders.

But is not only about reporting; Integrated Reporting encompasses Integrated Thinking.  It is as much about how companies do business and how they create value over the short, medium and long term as it is about how this value story is reported.

It means the integrated representation of a company’s performance in terms of both financial and other value relevant information. Integrated Reporting provides greater context for performance data, clarifies how valuable relevant information fits into operations or a business, and may help make company decision making more long-term. While the communications that result from IR will be of benefit to a range of stakeholders, they are principally aimed at providers of financial capital allocation decisions.

IR helps to complete financial and sustainability reports. A framework has been published, but some questions remain in order to know how to apply it. Do we need a new report? Do we need one report ? Will this report be useful for investors, and for other stakeholders? Other questions could have been raised, such as who is really working for an integrated reporting, and who has interests in it.

There are a multitude of benefits associated with Integrated Reporting – both within an organisation and from an external perspective.

• Clearer articulation of strategy and business model.
• Encouraging your organisation to think in an integrated way.
• A single report that is easy to access, clear and concise.
• Linking of non-financial performance more directly to the business.
• Better identification of risk and opportunities.
• Improved internal processes leading to a better understanding of the business and improved decision-making process.
• Creating value for stakeholders through identification and measurement of non-financial factors.

Long-term benefits

Integrated reporting offers a more cohesive and efficient approach to corporate reporting across the short, medium and long-term, says Howitt. Academic and other research on adopting non-financial reporting demonstrates evidence of these benefits:

• Lower costs of raising capital
• A more stable long-term investor base
• Higher share price

Advantages:

Performance

This area of IR addresses how an organisation has performed against its strategy and what are its key outcomes. These outcomes can be internal or external for example, revenue, cash flow, customer satisfaction, brand loyalty, environmental impacts, etc.

Business model

An organisation’s business model is ‘its system of transforming inputs, through its business activities, into outputs and outcomes that aims to fulfil the organisation’s strategic purposes and create value over the short, medium and long term’ (IIRC). Many of the performance management models are particularly relevant here: for example, the value chain explicitly sets out inputs, processes and outputs and requires organisations to understand how value is added so that profits can be made. If a company does not understand where it adds value then the company is existing in a temporary state of good fortune. It is making profits now, but does not understand why, so chance of continued success must low.

Opportunities and Risks

These must cover both internal and external matters. The traditional SWOT analysis usually categorises opportunities and threats (risks) as external, but it is essential to also look internally. A weakness (for example arising from gaps in new product development) is a risk to future revenues.

A shut-down decision is that the firm is temporarily suspending production. It does not mean that the firm is going out of business. The shut Down decision depends on Shut Down Point. The shutdown point denotes the exact moment when a company’s revenue is equal to its variable costs.

A Shutdown point is a position of operation at which a company is receiving no advantage for continuing operations Thus, decides to shut down temporarily or in some cases permanently.

Loss-making segments of a business such as products, customers, and locations can be a significant drain on the resources of an organization.

Keeping a segment of business that is consistently generating a loss can be hard to justify, especially if its economics are unlikely to improve in the future.

Shutdown decisions can, however, be daunting for a business because of the time and resources invested in the failing enterprise. Shutdown problems should also consider the long-term implications of the decision.

The shutdown point denotes the exact moment when a company’s revenue is equal to its variable costs. Variable costs such as wages, production supplies, etc. It results from the combination of output and price where the company earns just enough revenue to cover its total variable costs.

Reasons of shut down production

• Financial problem
• Fall in demand
• Change in technology
• Inadequate availability of raw material
• High rate of taxes
• Recession in market
• Mismanagement

Shutdown Point

Theoretically, a business should discontinue any activity that does not generate sufficient funds to pay for its expenses in the long term (i.e., positive net cash flow).

When assessing shutdown problems, it is essential to consider only the relevant costs of business activity.

Examples of relevant costs include:

• Direct fixed costs which are avoidable in case of a closure.
• Variable expenses such as direct material and direct labor.
• Opportunity cost of continuing a business activity.

Examples of non-relevant costs include:

• Sunk cost (e.g., cost of machinery).
• Non-cash expenses (e.g., depreciation)
• Committed expenses which are unavoidable;
• ‘One-off’ revenues and expenses (e.g., sale of machinery, redundancy payments, etc.) that do not reflect the underlying profitability of the business.

Types of Shutdown Points

The length of a shutdown can be temporary or permanent, this depends on the nature of the economic conditions which is leading to the shutdown. For the non-seasonal goods, in an economic recession, this may reduce the demand from the consumers, after forcing a temporary shutdown (partially or totally) until the economy recovers from this.

Yet at other times, the demand dries up completely for the changing consumer preferences, also for the technological upgrade. For example, nobody produces the cathode-ray tube (CRT) televisions or computer monitors any longer, and thus this would be a losing prospect to open a factory such as these days to produce the same.

Other businesses also may experience the fluctuations or produce some goods year-round, while others are merely produced seasonally. For example, the Cadbury chocolate bars are produced year-round, while the Cadbury Cream Eggs are considered as a seasonal product. The main operations will be focused on the chocolate bars, which may remain operational year-round, while the cream egg operations will have to go through periods of a shutdown during the off-season as well.

The sell or process further decision is the choice of selling a product now or processing it further to earn additional revenue. This choice is based on an incremental analysis of whether the additional revenues to be gained will exceed the additional costs to be incurred as part of the additional processing work.

For example, if a green widget can be converted into a red widget at an incremental cost of Rs. 1.00 per unit, then processing further is a good idea as long as the incremental price gain to be achieved is at least Rs. 1.01 per unit.

The decision to sell now or process further boils down to which choice will result in higher profits. Split-off point refers to the moment in the manufacturing process when different products become separately identifiable.

If the incremental sales revenue is greater than incremental costs, it makes sense to process further. Otherwise, it is better to sell at the split-off point.

The sell or process further decision most commonly arises when two or more products are generated by a manufacturing process. At the point when the products can be split apart (the split-off point), there is a choice to sell the goods immediately or attempt to capture additional value by engaging in more processing. This decision may vary over time, based on changes in the market prices of a product at each stage of processing. If the market price declines for a later-stage product, it can make more sense to sell it without additional processing. Conversely, if the market price increases for a later-stage product, the better choice may be to continue with additional processing in order to reap higher profits.

Example

Hyderabad XYZ Company manufactures three products. In one production batch, the company incurs Rs.25,000 manufacturing costs up to the split off-point (the point in the manufacturing process when the products can be separately identified). The following summarizes the further processing costs beyond the split-off point and ultimate sales value.

The company can sell the products at split-off point. The expected sales revenues at split-off point are: Product 1 – Rs.24,000, Product 2 – Rs.8,000, Product 3 – Rs.7,000. Which products should be sold at split-off point and which products should be processed further?

Solution:

Product 1 should be sold at split-off point. The increase in sales revenue amounting to Rs.66,000 (i.e., from Rs.24,000 to Rs.90,000) is less than the costs to process the product further (Rs.72,000). Hence, it is better to sell the product at split-off point than process it further. Product 2 and Product 3 could be processed further since it will result in incremental profits.

Special order pricing is the price which the company can offer to their customers due to the large quantity or building a good relationship with customers in order to make potential next order. Due to these reasons, the company will try to offer a special price which is usually below the standard price.

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.

Special order pricing is a technique used to calculate the lowest price of a product or service at which a special order may be accepted and below which a special order should be rejected. Usually, a business receives special orders from customers at a price lower than normal. In such cases, the business will not accept the special order if it can sell all its output at normal price. However when sales are low or when there is idle production capacity, special orders should be accepted if the incremental revenue from special order is greater than incremental costs.

A company is producing, on average, 10,000 units of product A per month despite having 30% more capacity. Costs per unit of product A are as follows:

The company received a special order of 2,000 units of product A at Rs. 17.00 per unit from a new customer. Should the company accept the special order, provided that the customer has agreed to pay the variable selling expenses in addition to the price of the product?

Solution

The increment cost per unit for the special order is calculated as:

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.