These lectures cover decision cost special orders which discusses relevant cost, irrelevant cost, idle capacity, opportunity cost and sunk cost.
CPA Questions: Cost decision: Special Order
Managers must often evaluate whether a special order should be accepted, and if the order is accepted, the price that should be charged. A special order is a one-time order that is not considered part of the company’s normal ongoing business.
Only the incremental costs and benefits are relevant. Because the existing fixed manufacturing overhead costs would not be affected by the order, they are not relevant.
Everything in this session consists of applications of one simple but powerful idea—only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits are irrelevant and should be ignored. In particular, sunk costs are irrelevant as are future costs that do not differ between alternatives.
This simple idea was applied in a variety of situations including decisions that involve adding or dropping a product line, making or buying a component, accepting or rejecting a special order, using a constrained resource, and processing a joint product further. This list includes only a small sample of the possible applications of the relevant cost concept. Indeed, any decision involving costs hinges on the proper identification and analysis of the costs that are relevant. We will continue to focus on the concept of relevant costs in the following chapter where long-term investment decisions are considered.
The relevant cost decision rule for special orders discussed earlier must be used with caution: done on a regular basis, relevant-cost pricing can erode normal pricing policies and lead to a loss in long-term profitability for firms such as TTS. The failure of large companies in the airline, auto, and steel industries has been attributed to their excessive relevant-cost pricing because a strategy of continually focusing on the short term can deny a company a successful long term. Special-order pricing decisions should not become the centerpiece of a firm’s strategy.