Preparing Financial Forecast
Acceptance of a Special Order
This concept of marginal costing is useful to consider when a customer requests goods at a price that is less than these goods normally sell for. The crucial factors to consider are:
; The available capacity of your factory
; The Opportunity Cost of deploying scarce resources
to make the goods
; The chance of future work from this customer ; The chance for future orders for these goods at a
; The likelihood of other customers, who are currently
paying the higher price, finding out that you sold
goods at a cheaper price and, therefore, demanding a
price cut for further work.
Echo Limited manufactures a product with variable costs of ?8 per unit and a
selling price of ?10.50. Foxtrot Limited asks if they can have 2,000 units in addition to their ordinary order but at a special price of ?10 per unit. Should the company agree to the new order?
Solution to Example 2.13
； From a marginal costing point of view, the solution is simple. ； As the variable costs of the product are ?8, any selling price
above this amount will give a contribution; if any activity gives a
contribution, it is worthwhile undertaking.
； On financial grounds, therefore, it is worthwhile accepting the
order at the reduced selling price.
； There are other factors, which would need to be
considered before a decision is taken:
a) Will the acceptance of one order at a lower price lead other customers
to demand lower prices as well?
b) Is this special order the most profitable way of using spare capacity?
c) Will the special order lock up capacity, which could be used for future
full- price business?
d) Is it absolutely certain that Fixed Costs will not alter?
； The management of Echo Limited will require to take these
considerations into account, before arriving at a decision.
Sell or Process Further Decision
？ Doing something additional with a view to adding value to the firm. ？ The most obvious example is a decision to process a semi-finished
product further, rather than selling it in its present condition. ？ The justification for processing further must be a net advantage
over the decision to sell now.
？ Other common examples of the sell or process further decision lie
in the marketing of products, such as improving the presentation of
a product by improved packaging, and selling a product in a
differentiated market at a higher price.
Answer to SAQ 2.4
Hunter Limited (i)
Selling Price 50
Less: Variable costs
Direct Material 19
Direct Labour (4 hours at ?1.75) 7
Contribution ? 24
(ii) Contribution per labour hour = Contribution
Number of hours to make one unit
?24 = ?6
Cost of making Component ?
1. Materials 150
2. Labour (20 hours x ?1.75) 35
3. Opportunity Cost: (20 hours x ?6) 120
Advice: Buy the component from the outside supplier at ?300.
? (a) Cost of Contract
1. Materials 1,800
2. Component 300
3. Labour (300 hours x ?1.75) 525
4. Opportunity Cost: (300 hours x ?6) 1,800
(b) Additional Profit if Contract accepted ?
Contract Price 4,800
Less: Contract Cost 4,425
?375 Additional Profit
1. selling price: $680 2. opportunity cost: $5000 3. additional fixed cost: $ 3000
4. material cost: 85%
1. selling price: $ 680
2. labor cost: 1.5 times
3. material cost: 85%
Advice: Hunter Limited should accept the contract
Ferguson Limited produces 3 products R, S and T. R has a selling price of ?3 per unit. The selling price of S is ?7 per unit, whilst the selling price of T is ?4.
Direct Labour is paid at the rate of ?4 per hour.
Trading results for the next six months are expected
R S T Total
? ? ? ?
Sales Revenue 120,000 87,500 120,000 327,500
Less: Variable Costs
Direct Materials 47,000 55,000 45,000 147,000
Direct Labour 21,000 15,000 24,000 60,000
Direct Overhead 42,000 30,000 21,000 93,000
110,000 100,000 90,000 300,000
Contribution 10,000 -12,500 30,000 27,500
Less: Fixed Costs 20,000
Profit ? 7,500
(a).On the basis that Fixed Costs can be charged to products on a basis
of 33.33% of departmental Direct Labour Cost, calculate the BEP
in terms of units and sales values for Products R, S and T.
The management of Ferguson Limited are considering two projects to
(b). Project one would be to reduce labour hours to 10,000 by ceasing
production of Product S and reducing production of either
Product R or Product T. Employees affected by this reduction in
manufacturing would lose their jobs. All of the fixed costs
attributable to Product S would be reduced to zero. However the
fixed costs associated with Product R and Product T would
remain unchanged. Calculate the Change in Profit.
(c) The second project involves the manufacture of component W,
which is a vital part of Product R. Half the time in department K
(where R Is produced) is spent in making 80,000 units of
component W. This component incurs material costs of 20p per
unit and variable overhead costs of 10p per unit. This component
can be bought from an outside supplier for ?23,000. Assuming
that Ferguson buy-in the component, the labour released could do
other work, which would make a contribution of ?2,000 to
Advise the Management of Ferguson Limited if the Projects Should Proceed.
； This section of the guide has reviewed short-term
； The tools applied have adopted the principles of
； It is the contribution to fixed costs which is
considered to be of paramount importance. ； By maximising contribution, it is assumed that the
firm will maximise profit.
； These concepts are borrowed from Economics,
where profit maximisation, as you may recall, is
considered the prime motivator for economic
We have considered these principles, in some detail, by applying them to a variety of typical management decisions, namely:
; Make a commodity ourselves, or buy in ; Changing the selling price of a commodity ; Changes in the cost structure
; Acceptance of an order with special conditions;
; It assumes costs can be classified between fixed and variable
; Linearity, where revenue and variable costs increase in proportion
; It ignores qualitative factors (i.e. those which can not be quantified) ; The relevant range may be fairly narrow.
Concepts you should be aware associated with marginal costing:
Make or Buy
Sell or Process Further
Keep open or close.