Accounting Business Reporting for Decision Making

CHAPTER 10 Cost–volume–profit analysis 443

ILLUSTRATIVE EXAMPLE 10.7

Special order with no idle capacity

Specialised Fitters has now placed another order with Brooks Enterprises, asking for the same contrac-

tual arrangements as last time. Despite the time difference, all income and costs have remained the

same. However, Brooks Enterprises’ anticipated new customer orders have now fully used its additional

production capacity of 20 000 swimsuits. Should the order be accepted this time? The last order

increased Brooks Enterprises’ profits by $14 850. However, this new order has created an opportunity

cost, which is the contribution margin of forgone regular sales. As the production capacity is fully uti-

lised, the only option available to satisfy the order is to reduce current sales by 500 units. The financial

analysis of the new order calculates a loss of $8900 for Brooks Enterprises if this order is accepted.

Relevant costs and income of special order

Benefit of special order (refer to example 10.6)

Opportunity cost

Contribution margin forgone on 500 swimsuits × ($75 − $27.50)

$ 14 850

(23 750)

Loss generated from special order $ (8 900)

Therefore, Brooks Enterprises should not accept Specialised Fitters’ offer. The difference between the first

order (which generated a profit of $14 850) and the second order (which would result in a loss of $8900) is due

to the lack of available capacity for the second order. The statement of profit or loss would change as follows:

Statement of profit or loss (contribution margin format)

with existing

sales

with special

order

Revenue

120 000 units × $75

119 500 units × $75

500 units × $70

$ 9 000 000

$8 962 500

35 000

Total revenue $ 9 000 000 $8 997 500

Less: Variable costs

120 000 units × $27.50

119 500 units × $27.50

500 units × $30.30

$ 3 300 000

$3 286 250

15 150

Total variable costs $ 3 300 000 $3 301 400

Contribution margin $ 5 700 000 $5 696 100

Less: Fixed costs

Additional fixed costs

$ 1 500 000 $1 500 000

5 000

$ 1 500 000 $1 505 000

Profit $ 4 200 000 $4 191 100

VALUE TO BUSINESS

•   Relevant costs and income need to be identified for short-term decision making. Relevant costs and

income are those that differ for each alternative.

•   For special orders, current fixed costs are considered irrelevant because it is expected that such

costs will not change within the relevant range in the short term.

•   Capacity is an important determinant of opportunity costs for special order decisions.

•   Avoidable costs need to be identified for outsourcing decisions.