Accounting Business Reporting for Decision Making

CHAPTER 10 Cost–volume–profit analysis 441

However, what would be the effect if the special order required 20 000 units? To accept the special order

in full, the entity would need to make use of the 10 000 units available, as well as directing 10 000 units

from the normal production to the special order. The loss of contribution margin from the 10 000 units of

normal production would be considered an opportunity cost and a relevant cost of the special order.

Furthermore, how would the entity’s normal customers react if their deliveries were affected? Man-

agement would need to make a judgement about the potential effect of the decision to forgo 10 000 units

of normal sales for the special order. Normal customers may react negatively to late deliveries or the

knowledge that other customers were getting a better deal. An entity could increase production capacity

by working overtime hours so that normal production would not be affected, but this would lead to

increased costs for the special order.

Illustrative example 10.6 demonstrates the assessment of a special order for an entity with idle capacity.

ILLUSTRATIVE EXAMPLE 10.6

Special order with idle capacity

Brooks Enterprises manufactures a popular range of swimwear. Due to an anticipated increase in

customer orders over the next few years, the entity has recently expanded its production capacity by

20 000 swimsuits. Its current output is 100 000 swimsuits that sell in the market for $75 each. The cur-

rent costs are as follows.

Variable costs

Direct material

Direct labour

Indirect

$ 800 000

1 200 000

750 000

Fixed costs

$ 2 750 000

1 500 000

Total costs $ 4 250 000

Based on current sales, Brooks Enterprises is generating a profit of $3 250 000. The statement of

profit or loss, therefore, would be as follows.

Statement of profit or loss (contribution margin format)

Revenue

Less: Variable costs

$7 500 000

2 750 000

Contribution margin

Less: Fixed costs

4 750 000

1 500 000

Profit $3 250 000

A local boutique, Specialised Fitters, has requested the supply of 500 swimsuits manufactured

to its own design, and has offered to pay $70 per swimsuit. The order will increase direct labour

by 10 per cent and direct material by 20 per cent. In addition, $5000 will be charged to program the

machinery to cut the fabric for the new design.

Brooks Enterprises is interested in this special order, as it has available capacity of 20 000 units due

to its recent expansion to meet future customer demand. Therefore, the 500 swimsuits requested by

Specialised Fitters can be satisfied by the available capacity. The financial analysis will consider the

incremental income and incremental costs. Existing fixed costs are irrelevant as the 500 swimsuits are

within the relevant range. The unit cost for the regular swimsuits is as follows.

Variable cost per swimsuit

Direct material ($800 000/100 000 units)

Direct labour ($1 200 000/100 000 units)

Indirect ($750 000/100 000 units)

$ 8.00

12.00

7.50

Variable cost per unit $27.50