Question 18.4: A special order Amber Limited has been asked by a customer t...
A special order
Amber Limited has been asked by a customer to supply a specially designed product. The customer has indicated that he would be willing to pay a maximum price of £100 per unit. The cost details are as follows.
| Unit cost | £ | £ |
| Contract price | 100 | |
| Less: Variable costs | ||
| Direct materials | 40 | |
| Direct labour (2 hours) | 30 | |
| Variable overhead | \underline{10} | \underline{80} |
| Contribution | \underline{\underline{20} } |
At a contract price of £100 per unit, each unit would make a contribution of £20. The customer is prepared to take 400 units, and so the total contribution towards fixed costs would be £8000 (400 units × £20). However, Amber has a shortage of direct labour and some of the staff would have to be switched from other orders to work on the special order. This would mean an average loss in contribution of £8 for every direct labour hour worked on the special order.
Required:
Determine whether Amber Limited should accept the special order.
In order to determine whether Amber Limited should accept the special order, the extra contribution should be compared with the loss of contribution by having to switch the workforce from other orders. The calculations are as follows.
| £ | |
| Total contribution from the special order (400 units × £20 per unit) |
8 000 |
| Less: the opportunity cost of the normal contribution foregone
[800 direct labour hours (400 units × 2 DLH) × £8 per unit] |
\underline{\underline{6 400} } |
| Extra contribution | \underline{\underline{1 600} } |
Before coming to a decision, the following points should also be considered. You will see that they range well beyond simple cost factors.
Tutorial notes
1 The costings relating to the special order should be carefully checked.
2 The customer should be asked to confirm in writing that it would be willing to pay a selling price of £100 per unit.
3 Determine whether the customer is likely to place additional orders for the product or not.
4 Check that the average contribution of £8 per direct labour hour, obtained from other orders applies to the workforce that would be switched to the special order, i.e. is the contribution from the other orders that would be lost more or less than £8 per direct labour hour?
5 Is it possible that new staff could be recruited to work on the special order?
6 Is more profitable work likely to come along in the meantime? Would it mean that it could not be accepted during the progress of the order?
Recommendation
Assuming that the points raised in the above notes are satisfied, then the recommendation would be to accept the special order at a price of £100 per unit. This would mean that Amber’s total contribution would be increased by £1600.