A business may receive a special order at a price that is significantly different from the normal pricing scheme. The quantitative analysis will focus on the contribution margin associated with the special order. In other words, it must be determined whether the special order sales price exceeds the variable production and selling costs associated with the special order.
To illustrate, assume that Lunker Lures Company produces the popular Rippin' Rogue pictured at right. The "cost" to produce a Rippin' Rogue is $1.10, consisting of $0.20 direct materials, $0.40 direct labor, and $0.50 factory overhead. The overhead is 30% variable and 70% fixed cost allocation. Lunker Lures are sold to retailers across the country through an established network of manufacturers' representatives who are paid $0.10 for each lure sold in their respective territories.
Lunker Lures has been approached by Walleye Pro Fishing World to produce a special run of 1,000,000 units. These lures would be sold under the Walleye Wiggler brand name and would not otherwise compete with sales of Rippin' Rogues. Walleye Pro Fishing World's offer is priced at $1.00 per unit. Lunker Lures is obligated to pay its representatives half of the normal rep fee for such private label transactions. On the surface it appears that Lunker Lures should not accept this order. After all, the offer is priced below the noted cost of production. However, so long as Walleye Wigglers do not compete with sales of Rippin' Rogues, and Lunker Lures has plenty capacity to produce lures without increasing fixed costs, profit will be enhanced by $200,000 ($0.20 x 1,000,000) by accepting the order. The following analysis focuses on the relevant items in reaching this conclusion:
Selling price per unit $ 1.00 Direct material per unit $ 0.20
Direct labor per unit 0.40
Variable factory overhead per unit ($0.50 X 30%) 0.15 0.75
Manufacturing margin $ 0.25
Variable selling costs (50% of normal) 0.05
Contribution margin $ 0.20
Note: Aggregate fixed costs will be the same whether the special order is accepted or not. The per unit allocation of fixed costs is not relevant.
Capacity Constraints and the Impact on Special Order Pricing
A potential error in special order pricing is acceptance of special orders offering the highest contribution margin per dollar of sales, while ignoring capacity constraints. Notice that the special order for Walleye Wigglers offered a 20% contribution margin ($0.20/$1.00). Suppose Bass Pro Fishing World also placed a special order for a Bass Buzzer lure, and that special order afforded a 30% margin on a $1.00 per unit selling price. At first glance, one would assume that the Bass Pro Fishing World would represent the better choice. But, what if you were also informed that remaining plant capacity would allow production of either 1,000,000 Walleye Wigglers or 600,000 Bass Buzzers? Now, the total contribution margin on the Wiggler is $200,000 (1,000,000 units x $0.20) while the total contribution on the Buzzer is $180,000 (600,000 x 30%). The better choice is to go with the Wiggler, as that option maximizes the total contribution margin. This important distinction gives consideration to the fact that producing a few units (with a high per-unit contribution margin) may be less profitable than producing many units (with a low per-unit contribution margin). Contribution margin analysis should never be divorced from consideration of factors that limit its generation! The goal will be to optimize the total contribution margin, not the per unit contribution margin.