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BAHRIA UNIVERSITY ISLAMABAD

COST & MANAGERIAL ACCOUNTING PROJECT


ACCEPTING OR REJECTING SPECIAL ORDERS

“IDLE CAPACITY”

SUBMITTED TO: MISS SAHAR ZEAST

GROUP MEMBERS:

 MUHAMMAD MUZAMMAL [01-322191-014]


 MUHAMMAD HARIS KHAN [01-322191-012]
 AMMAD SHAKIR KHAN [01-222162-059]
 ABID ALI [01-322191-031]

1 | Accepting or Rejecting Special Orders-Idle Capacity


Abstract

The purpose of this report was to understand the cost and managerial accounting key
concepts and knowledge to a specific organization and how managers use data to help them
in making decisions. Since the topic assigned to us is Accepting or Rejecting special orders at
idle capacity.

Both manufacturing and service companies often receive requests to fill special orders.
These special orders are typically for goods or services at a reduced price and are usually a
one-time order that, in the short-run, does not affect normal sales. When deciding whether
to accept a special order, management must consider several factors such as; The capacity
required to fulfill the special order, Whether the price offered by the buyer will cover the
cost of producing the products or performing a service, The role of fixed costs in the
analysis, Qualitative factors, Whether the order will violate the Robinson-Patman Act and
other fair pricing legislation.

1. Introduction

2 | Accepting or Rejecting Special Orders-Idle Capacity


There are times when a customer places a special order for a large volume at lower prices
than that usually charged by the business. In this event, the business should properly decide
whether to accept or reject the special order. The rule is to accept the order if benefits
exceed costs.

When the company is operating at less than its maximum capacity and the company has
enough capacity to produce and fill the special order, the order should be accepted if the
additional sales exceed the additional variable costs.

When the company has no excess capacity, the cost to be considered must include the lost
contribution margin from sacrificing regular sales to be able to fill up the special order.

When there is idle capacity or when sales are low, you can accept special orders as long as
the incremental revenue surpasses incremental costs. When production is running at full
capacity, more calculations are required in decision making.

The condition in which a company will accept a special order is when a special order will
typically involve a large quantity of products or service at a specified price. Your accounting
manager's feedback will hinge on how to maximize your profit. The proposal should be
accepted only if the incremental revenue associated with the special order exceeds
incremental costs and if present sales will be unaffected.

With fixed costs already accounted for in regular production, you will need to optimize the
price point based on the variable costs to turn a profit. Soft benefits, like maintaining a
business relationship, should be considered as well.

2. Factors of accepting or rejecting a special orders


The following factors generally influence on acceptance and rejection of special orders:

 The capacity required to fulfill the special order

The starting point for making this decision is to assess the company’s normal production
capacity. The normal capacity is the production level a company can achieve without adding
additional production resources, such as additional equipment or labor.

Most companies do not work at maximum capacity; rather, they function at normal
capacity, which is a concept related to a company’s relevant range. The relevant range is the
quantitative range of units that can be produced based on the company’s current
productive assets. These assets can include equipment capacity or its labor capacity. Labor
capacity is typically easier to increase on a short-term basis than equipment capacity. The

3 | Accepting or Rejecting Special Orders-Idle Capacity


following example assumes that labor capacity is available, so only equipment capacity is
considered in the example.
If the company does not have the capacity to produce a special order, it will have to reduce
production of another good or service in order to fulfill the special order or provide another
means of producing the goods, such as hiring temporary workers, running an additional
shift, or securing additional equipment. As you will learn, not having the capacity to fill the
special order will create a different analysis than it would if there is sufficient capacity.

 Price offered by the buyer will cover the cost of production or service:

Next, management must determine if the price offered by the buyer will result in enough
revenue to cover the differential costs of producing the items. For example, if price does not
meet the variable costs of production, then accepting the special order would be an
unprofitable decision.

 Role of fixed cost in Analysis:

Additionally, fixed costs may be relevant if the company is already operating at capacity, as
there may be additional fixed costs, such as the need to run an extra shift, hire an additional
supervisor, or buy or lease additional equipment. If the company is not operating at capacity
—in other words, the company has unused capacity—then the fixed costs are irrelevant to
the decision if the special order can be met with this unused capacity.

 Qualitative Factors:

Special orders create several qualitative issues. A logical issue is the concern for how
existing customers will feel if they discover a lower price was offered to the special-order
customer. A special order that might be profitable could be rejected if the company
determined that accepting the special order could damage relations with current customers.
If the goods in the special order are modified so that they are cheaper to manufacture,
current customers may prefer the modified, cheaper version of the product. Would this hurt
the profitability of the company? Would it affect the reputation?
In addition to these considerations, sometimes companies will take on a special order
that will not cover costs based on qualitative assessments. For example, the business
requesting the special order might be a potential client with whom the manufacturer has
been trying to establish a business relationship and the producer is willing to take a one-
time loss. However, our coverage of special orders concentrates on decisions based on
quantitative factors.
Companies considering special orders must also be aware of the anti–price
discrimination rules established in the Robinson-Patman Act. The Robinson-Patman Act is a
federal law that was passed in 1936. Its primary intent is to prevent some forms of price
discrimination in sales transactions between smaller and larger businesses.
The Robinson-Patman Act prevents large retailers from purchasing goods in bulk at a greater
discount than smaller retailers are able to obtain them. It helps keep competition fair
between large and small businesses and is sometimes called the “Anti-Chain Store Act.”

4 | Accepting or Rejecting Special Orders-Idle Capacity


4. Example of Accepting and Rejecting Special order-IDLE CAPACITY

Frontier Works Organization (FWO):


Frontier Works Organization (FWO), today’s most versatile and vibrant construction firm,
was established on 31 October 1966 to wrought a miracle and carve out a modern highway,
the Karakoram Highway, across crags and crevices of the highest mountain ranges of the
world. It was towards the completion stage of KKH that the Government analyzed the
tremendous potential of FWO in carrying out civil engineering projects in difficult and
inhospitable areas and decided not only to keep FWO in existence, but also to expand its
tentacles throughout the country.

FWO History:

For the last 53 years FWO has left its imprints, bringing prosperity to utterly backward and
forgotten areas from the sun burnt plateaus of Baluchistan to lush green dales of Swat and
Chitral and from the deserts of Sindh to snow capped Siachin. Over these years FWO has
worked in diversified fields to include development of communication infrastructure like
construction of roads, railway lines and airfields; irrigation like construction of dams, canals
and barrages; power projects like thermal and hydal; tunneling and mining;
telecommunication; construction of residential and industrial infrastructure and proved its
unmatched qualitative and quantitative capabilities.

In 1991, FWO was called upon to participate in the reconstruction phase of Kuwait, after the
Gulf war, and given to clear 3000 square kilometers of highly mined area, littered with large
quantity of ammunition left behind by the withdrawing Iraqi Army. FWO cleared the area in
a record time of just 16 months, ahead of others construction forms of USA, UK, France,
Egypt and Bangladesh. Similarly, in 2006, FWO constructed a road from Torkham to
Jalalabad in the most hostile and difficulty security environment.

With professionally qualified and competent staff, efficient work force, flexible organisation
and a large pool of modern construction equipment and machinery FWO is capable of
undertaking any construction assignment at short notice anywhere in Pakistan or abroad.
FWO, motto ‘Sustaining Excellence’ amply speaks of the continued efforts to deliver the
best.

5 | Accepting or Rejecting Special Orders-Idle Capacity


Problem Statement

A study was conducted, with an objective weather to accept or reject a special order on the
basis of idle capacity of a construction organization. In this study an organization named
FWO has to decide whether to accept or reject an order of working in hilly areas besides
working in a plain and normal areas. Is the pricing and costing of their work will rather be
profitable in working of hilly areas as it is in plain area?

■ Currently FWO working on HAZARA MOTERWAY projects with the government which
requires them to do piling For Bridge Construction in hilly areas.

Cost of single pile bore at normal Ground Cost of single pile bore at Hilly Area
Area  
Rs. 16000 per meter
Rs. 6000 per meter
 
Cost of 08 pile bore at normal Ground Cost of 08 pile bore at Hilly Area
Area  
16000 /m x 20 m x 8= Rs. 2,560,000
6000/m x 20 m x 8 = Rs. 960,000
 
 
Entity Ground Area Hilly Area
Rs. 6000/m x 20 m x 8 bore = Rs. Rs. 16000/m x 20 m x 8
Revenue
960,000 bore = Rs. 2,560,000
Operation Days Average 5 Days Average 20 Days
Direct Labor(10 + 3 people) 350,000 / project 900,000 / project
Rs. 25,000 / bore x 8 bore =Rs. Rs. 100,000 / bore x 8
Direct Material Fuel
200,000 bore =Rs. 800,000
Rs. 10,000 / bore x 8 bore =Rs. Rs. 40,000 / bore x 8
Overheads
80,000 bore =Rs. 320,000
Supervision Charges Rs. 30,000 / project Rs. 50,000 / project
Total Cost Rs. 660,000 Rs. 2,070,000
Net Income Rs. 300,000 Rs. 490,000

Incremental Revenue and Incremental cost comparison on this special order

Increase in Revenue Rs. 1,600,000  


Increase in the Cost Rs. 1,410,000
Net Income Rs. 190,000

This shows that the incremental costs are less than the incremental revenue, so the company should
accept this special order.

6 | Accepting or Rejecting Special Orders-Idle Capacity


Utilization of Constraints resources

■ Drilling machine is used in piling works.


■ A drilling machine can work 5 days a week which is its maximum capacity.
■ In this case drilling machine is Company constrained resource.

Entity Project G Project H


Rs. 6000/m x 20 m =Rs. Rs. 4000 x 20 m =Rs.
Revenue
120,000 / bore 80,000 / bore
Operation Days Average 5 Days Average 2 Days
Variable Expenses Rs. 69,000 / project Rs. 35000 / project
Net Income / days Rs. 51,000 / 5 days Rs. 45,000 / 2 days

Monthly Demand for Project G is 3 projects per month and for project H is 4 projects per month.

Entity Project G Project H


Rs. 45000 x 4 = Rs.
Revenue Rs. 51000 x 3 = Rs. 153000
180,000

As Project H takes less time and contributes in per week earnings so we will emphasize on project H first
and then utilize the left time for project G.

Project H full and using


Project G full and using the
Entity the remaining time for
remaining time for project H
project G
Rs. 51000 x 3 + Rs. 45000 x 2 Rs. 45000 x 4 + Rs. 51000
Revenue
=Rs. 243,000 x 2 = Rs. 282,000

 Now as it is clear that using machine on project H and then on project G would increase the
contribution margin
 So this analysis will tell us that how to use the resources efficiently i.e. the drilling machine in this
scenario efficiently so that we can generate maximum revenue.

Contribution margin
Entity Contribution margin Project G
Project H
Rs. 45000 x 4 = Rs.
Revenue Rs. 51000 x 2 = Rs. 102,000
180,000

So the total contribution margin is Rs. 282,000.

7 | Accepting or Rejecting Special Orders-Idle Capacity


Utilization of
Entity Special Order
Constrained Resources
Profit Rs. 190,000 Rs. 282,000

5. Conclusion

In this Project We study How to Accept or Reject the special order, This will help the
manager to take a decision about Acceptance or Rejection of Special Order and Utilization of
Constraints Resources to maximize the Profit.

8 | Accepting or Rejecting Special Orders-Idle Capacity