Differential Analysis

Assessing Special Orders

Managers often use differential analysis to decide whether to take on a special order.

A special order is a one-time request that is not part of a company's normal operating procedures and ongoing business practices. A company can use differential analysis to determine whether or not it is profitable to take on a special order.

The company will need to consider the opportunity cost of the special order. An opportunity cost is a potential benefit that a company gives up when it selects one alternative in place of another. In this case, the resources the company uses in producing the special order will not be available to put toward the company's normal ongoing needs. These resources may include raw materials, labor hours, showroom space, and warehouse space, among other factors.

To determine whether fulfilling the special order will require outside resources, a company may have to conduct a make or buy decision, which means the managers need to determine if it is possible to create the parts or units of the special order in-house or if the company should buy those parts or units from a vendor.

Torrent Motors normally produces cars and light trucks that it sells to consumers. The company may receive a request from a government agency to make a limited number of special police or militarized versions of their normal product vehicles.

To fulfill the special order, the company would need to retrofit its machines and assembly-line processes and incur additional material costs to make heavier-duty versions of its normal personal vehicles. There will also be increased labor costs associated with changing over the assembly line machines and vehicle building process to build these specialized vehicles, and costs to switch back to the normal processes once the specialized vehicles are built. Finally, the time Torrent spends converting the vehicle building process and the time it spends making the specialized vehicles is time not spent making the normal personal vehicles, so there is an opportunity cost associated with this special order.

In making its analysis, the company must determine what the total increase in production costs in completing the special order would be, along with the opportunity cost that would be incurred in making the special order. However, a special order would probably allow the company to charge a price far higher than what it normally charges for selling its regular personal vehicle units. Therefore, despite potentially significant additional costs and incurred opportunity costs, a company may still be better off fulfilling a special order if the revenue from that order is high enough.

Sample Analysis of Special Orders

This sample analysis shows the decision-making process a company might go through when its managers consider whether to take a special order.
Whether the company is operating at full capacity before receiving a special order can be a significant factor. If the company is not at full capacity, then there can be a significant reduction in costs of completing the special order. The lost opportunity cost may be zero or close to zero.

For example, assume that a company is operating its manufacturing plants at 80% capacity. A special order request comes in that will use 10% of the manufacturing plants' operating capacity. The company knows it can fulfill that special order without sacrificing any of its current regular operational order needs. Thus, the special order contains no opportunity cost because the company will not have to forgo any of its current revenues and operations to make the special order. The company will still have to weigh the costs of obtaining the materials for the special order, as well as the time and the monetary costs of converting its equipment to make the special order items, against the revenue that would be generated by completing the special order. However, the company will not have to worry about the opportunity lost in fulfilling its regular operation orders.

Assume that Bedtime Pillows manufactures bedding products, including decorative pillows. On average, the company produces 240,000 decorative pillows per year while operating at 80% capacity. Bedtime is able to sell the pillows for $20 per unit, with a variable cost of $12.50 per unit plus a fixed cost of $1,300,000.

Pillow Company Before Special Order

Bedtime Pillows Financials Before Special Order
Production: 240,000 units Per-Unit Price Total Revenues
Sales Revenue $20 $4,800,000
Fixed Costs 1,300,000
Variable Costs $12.50 3,000,000
Profit $500,000

Bedtime Pillows has substantial revenues and profits even before a special order of pillows comes in.

A customer wants to place a special order request for 50,000 specially monogrammed towels to send out as thank-you gifts to their existing customer base. The pillow company's factory has a total production capacity of 300,000 units per year, which means that the company can absorb this special order without sacrificing any of its current production levels. The special customer is willing to pay only $15 per unit because they expect a discount for such a large order.

Pillow Company Special Order Proposal

Bedtime Pillows Special Order Proposal
Production: 50,000 Units Per-Unit Price Total Revenues
Sales Revenue $15 $750,000
Fixed Costs $0
Variable Costs $12.50 $625,000
Profit $125,000

A special order for Bedtime Pillows could generate a substantial profit.

Completing this special order makes sense because it is profitable. There is no additional fixed cost, as Bedtime Pillows has been operating below capacity and can absorb the special order into its regular production. Even with the lower unit sales revenue price, the pillow company can still turn a profit on this special order.