Now that we understand relevant costs, let's move into some more complex decision making scenarios and consider some short-term decisions that managers might encounter. Let's start with the decision about rejecting or accepting a special order. Now what's a special order? Well, a special order is a one-time order. It could be from an existing customer or from someone else. And it generally won't lead to additional business from that customer. Now recall our T-shirt maker. Suppose the company receives a one-time special order for 2,000 basic T-shirts at $7 per shirt, from someone who is not a current customer. Let's take a look at the financial impact of accepting that special order. Recall our decision-making framework from earlier. First, we define the decision to be made. That decision is whether or not to accept the special order. Second, we identify the alternatives. There are two alternatives here, accept the special order or reject the special order. Third, we gather the information relevant to making the decision. Well, what information is that? Well, the special order will both generate additional revenues and will cause the company to incur additional costs. So we need to identify how much additional revenues and costs will be associated with that order. And at that point, we can evaluate and decide which alternative to choose. So we have two alternatives, Alternative 1 is to reject the special order, and Alternative 2 is to accept it. Now note if we reject the special order, things stay just as they are. The company will neither generate the additional revenues, nor incur the additional costs associated with that order. If we accept the special order, the company will generate additional revenues, and incur additional costs. Those additional revenues and costs will inform us in making our decision, because they will capture the difference between the two alternatives. If the additional revenues are higher than the additional costs, the financial analysis would suggest accepting the order. Now suppose we obtain information from the financial accounting system regarding the cost of making the basic T-shirt. Direct material is $4, direct labor is $2, manufacturing overhead is $1.50, and non manufacturing overhead is $0.70, for a total of $8.20. Now at first we might be tempted to use that information obtained directly from the financial accounting system, without any modifications, to do our analysis. So let's start by quantifying the additional benefits from the special order. The price offered is $7, and the quantity is 2,000. So the additional revenues are $14,000 if we accept the special order. Now let's look at the additional costs. Recall that the total cost for the basic T-shirt is $8.20. If we used that information, and assumed that we would incur an additional cost of $8.20 per shirt, the special order seems unattractive, because it appears to decrease profit. But, remember that some of that $8.20 per unit is variable and some is fixed. If we accept the special order for 2,000 units, we would expect to incur additional variable costs. However, we would not expect to incur any additional fixed costs. So let's go back to our cost data, identify the variable cost and the fixed costs, and then we'll rearrange the data according to the cost behavior. So that it looks like this, with variable costs grouped together and fixed cost grouped together. Now let's use that information to do our analysis. If we accept the special order, of course we generate the additional revenues of $14,000 dollars. And we will incur additional variable cost, but we will not incur any additional fixed cost. So the additional profit that we would make is equal to the total contribution margin of the 2,000 units in the special order. The contribution margin per unit, remember, is the $7 price minus the $6.41 in variable cost, or $0.59 per shirt. So the total contribution margin associated with the special order is the 59 cents per shirt times 2,000 shirts, or $1,180. Now with this more accurate analysis, we see that accepting the special order would increase profit. Now this all assumes we have the capacity to handle the special order, but what if we don't? In that case, we would have to add capacity, which we probably wouldn't want to do if it means adding fixed costs that we can't get rid of, since this is a very short term decision about a one time special order. So if we accept the special order, we would have to get rid of or forego some of our regular business. And in that case, the contribution margin we would forego on the regular business is an opportunity cost of accepting the special order, and it must be considered. So what is that amount? It's the $10 price that we would charge on our regular business minus the 6.41 in variable cost per unit, or $3.59 per unit. Multiply that times the 2,000 regular units we gave up, and we see we'd be giving up $7,180 in contribution margin on our regular business. When we factor that in it becomes clear that if we don't have the extra capacity, we shouldn't accept the special order. But, I mean, this makes sense, doesn't it? We would never want to give up T-shirts generating a contribution margin of $3.59 per shirt, to sell T-shirts that generate a contribution margin of only $0.59 per shirt.
