A one-off order priced below absorbed cost, worked through variable cost, order-specific costs, capacity and the opportunity cost of displaced sales, with the minimum price for each route.
Accept a special order when its price exceeds its relevant cost: the variable cost per unit, the costs the order itself causes, and any contribution lost on sales it displaces. An illustrative order of 200,000 units at 5.60 against an absorbed cost of 7.20 looks like a 320,000 loss, but on 5.00 of variable cost it adds 69,750 if the excess over spare capacity is made on overtime, and loses 24,000 if it displaces regular sales. The absorbed cost answers neither question.
Worked in full in Cost Accounting by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Special orders are where a standard cost does its most visible damage. Quote from the full cost and the factory turns away work that would have paid for itself; quote from variable cost alone and it fills capacity it needed for better business. The relevant-cost method sits between the two, and it needs four numbers that the standard cost card does not contain.
| Input | Value |
|---|---|
| Special order: quantity, price per unit | 200,000 at 5.60 |
| Direct material per unit | 3.10 |
| Direct labour per unit | 1.05 |
| Variable overhead per unit | 0.85 |
| Fixed overhead absorbed per unit | 2.20 |
| Regular selling price | 7.40 |
| Spare capacity in the period, units | 150,000 |
| Order-specific costs: setup and tooling; first-article inspection | 18,000; 6,000 |
| Overtime premium on direct labour | 50% |
Step 1: the misleading comparison. Absorbed cost is 3.10 + 1.05 + 0.85 + 2.20 = 7.20, so the order appears to lose 1.60 a unit, 320,000 in all. But the 2.20 of fixed overhead will be spent whether or not the order is taken.
Step 2: contribution and the costs the order causes.
Variable cost = 3.10 + 1.05 + 0.85 = 5.00; contribution = 5.60 − 5.00 = 0.60 a unit
Order-specific costs = 18,000 + 6,000 = 24,000
The setup and the inspection are fixed for the order but would not exist without it, so they are relevant. They are batch-level costs, exactly the kind a labour-hour overhead rate spreads thinly across everything instead of charging to the order that causes them.
Step 3: capacity. Only 150,000 units of spare capacity exist. The other 50,000 must come from somewhere, and each route has a different cost.
A. Accept 150,000 only: 150,000 × 0.60 − 24,000 = +66,000
B. Accept 200,000, displacing 50,000 regular units at 2.40 contribution: 120,000 − 24,000 − 120,000 = −24,000
C. Accept 200,000, making 50,000 on overtime at 0.525 a unit extra: 120,000 − 24,000 − 26,250 = +69,750
Excel: =(Price-VarCost)*Qty-OrderCosts-MAX(0,Qty-Spare)*ExtraCostPerUnit
The order is worth taking in full on overtime, for 69,750, or in part for 66,000. It is not worth taking in full if the extra units push regular customers out, because each displaced unit gives up 2.40 to earn 0.60. The answer to "should we accept an order below cost" is therefore conditional on capacity, and the minimum price makes the condition explicit:
| Route | Units | Minimum price |
|---|---|---|
| Spare capacity only | 150,000 | 5.16 |
| Full order, overtime for the excess | 200,000 | 5.25 |
| Full order, displacing regular sales | 200,000 | 5.72 |
| Absorbed cost, for comparison | 200,000 | 7.20 |
Minimum price = variable cost + (order-specific costs + lost contribution or extra cost) ÷ units. At 5.60 the order clears the first two floors and misses the third. The customer is asking for a 24.3 per cent discount on the regular price, and the factory can grant it profitably only if it does not need the capacity.
| Price | 150,000, spare only | 200,000, displacing | 200,000, overtime |
|---|---|---|---|
| 5.20 | 6,000 | −104,000 | −10,250 |
| 5.40 | 36,000 | −64,000 | 29,750 |
| 5.60 | 66,000 | −24,000 | 69,750 |
| 5.80 | 96,000 | 16,000 | 109,750 |
Every 0.20 on the price is worth 30,000 on the partial order and 40,000 on the full one. Below 5.25 the overtime route loses money, and at 5.20 the only acceptable answer is the partial order, which barely covers its setup.
If the factory costs overhead on labour hours, its "variable overhead" of 0.85 is itself an estimate. Check whether it truly moves with units; the setup and inspection costs above did not, and a costing system that hides them inside a unit rate will misprice every short run.
The table also shows why the route matters more than the price: at 5.80 the worst route still earns less than the best route does at 5.40.
The same decisions run on a full factory, with the avoidable share of each cost as an input you can change, are in the free workbook for this case. The mirror image of this decision is in should a factory buy a part quoted below its absorbed cost.
Variable cost plus order-specific costs per unit plus any lost contribution per unit. On an illustrative order, 5.00 of variable cost and 24,000 of setup and inspection give 5.16 for 150,000 units in spare capacity; 5.25 for 200,000 with overtime; and 5.72 if 50,000 units displace regular sales earning 2.40 each.
Because it does not change whether the order is accepted. Absorbed fixed overhead of 2.20 a unit, 30.6 per cent of the 7.20 full cost, is spent either way. Only costs the order causes, and contribution it displaces, are relevant. Fixed costs that the order would actually add, such as a setup, must be included.
When it could reprice the regular business. An order adding 69,750 is a poor trade if 5 per cent of 1,000,000 regular units, sold at 7.40, are later renegotiated to the special price of 5.60: that alone costs 90,000. Price discrimination has to be defensible and contained.
This article is one calculation from Cost Accounting. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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