Special Pricing Issues

Learning Outcomes

  • Use differential analysis in decision-making

During your career, you will run into a variety of special pricing issues. For example, sometimes management has an opportunity to sell its product in two or more markets at two or more different prices. Businesses like airlines and movie theaters, for example, sell tickets at discount prices to particular groups of people—children, students, and senior citizens, first-class, coach, and economy.

Good business management requires keeping the cost of idleness at a minimum. When operating at less than full capacity, management should seek additional business. Management may decide to accept such additional business at prices lower than average unit costs if the differential revenues from the additional business exceed the differential costs. By accepting special orders at a discount, businesses can keep people employed that they would otherwise lay off.

In this example, you’ll use differential analysis to determine whether a company should sell its products at prices below regular levels.

Assume Rios Company produces and sells a single product with a variable cost of $8 per unit. Annual capacity is 10,000 units, and annual fixed costs total $48,000. The selling price is $20 per unit and production and sales are budgeted at 5,000 units. Thus, budgeted income before income taxes is $12,000, as shown below.

Rios Company
Income Statement
For the period ending May 31
Description Amount 1 Amount 2 Total
Revenue (5,000 units at $20) $ 100,000
Subcategory, Variable costs:
      Direct materials cost ($4 per unit) $20,000
      Labor ($1 per unit) 5,000
      Overhead ($2 per unit) 10,000
      Marketing and administrative costs ($1 per unit)     5,000
            Total variable costs ($8 per unit) Single Line Single Line$40,000
Subcategory, Fixed costs:
      Overhead $28,000
      Marketing and administrative costs 20,000
            Total fixed costs Single Line       48,000
            Total costs ($17.60 per unit) Single Line         88,000
Net income Single Line$  12,000Double line

 

Assume the company receives an order from a foreign distributor for 3,000 units at $10 per unit. This $10 price is not only half of the regular selling price per unit, but also less than the $17.60 average cost per unit ($88,000/5,000 units). However, the $10 price offered exceeds the variable cost per unit by $2. If the company accepts the order, net income increases to $18,000.

Revenue would increase to $130,000 with the special order. Each of the variable costs increases in total by 60% because total volume increases by 60% (3,000 units in the special order/5,000 units regularly produced). The revised income statement would appear as follows:

Rios Company
Income Statement (incl. special order)
For the period ending May 31
Description Amount 1 Amount 2 Total
Revenue (5,000 units at $20 + 3,000 units at $10) $ 130,000
Subcategory, Variable costs:
      Direct materials cost ($4 per unit) $32,000
      Labor ($1 per unit) 8,000
      Overhead ($2 per unit) 16,000
      Marketing and administrative costs ($1 per unit)     8,000
            Total variable costs ($8 per unit) Single Line Single Line$64,000
Subcategory, Fixed costs:
      Overhead $28,000
      Marketing and administrative costs 20,000
            Total fixed costs Single Line       48,000
            Total costs ($14.00 per unit) Single Line         112,000
Net income Single Line$  18,000Double line

 

Note that the fixed costs do not increase with the special order. Because the special order does not increase the fixed costs, the special order’s revenues need only cover its variable costs.

If Rios Company continues to operate at 50% capacity (producing 5,000 units without the special order) it would generate income of only $12,000. By accepting the special order, net income increases by $6,000 ($18,000 net income with special order, $12,000 net income without special order).

A differential analysis would look like this:

Accept Reject Difference
Revenues $   130,000 $   100,000 $     30,000
Costs $   112,000 $    88,000 $     24,000
Net advantage (disadvantage) Single Line$      6,000Double line

 

Variable costs set a floor for the selling price in special-order situations. Even if the price exceeds variable costs only slightly, the additional business increases net income, assuming fixed costs do not change. However, pricing just above variable costs of special-order business often brings only short-term increases in net income. In the long run, companies must cover all of their costs, not just the variable costs.

Here is a comprehensive example of a special pricing decision:

You can view the transcript for “Management Product & Pricing Decisions: Special Order; Incremental Analysis – Accounting video” here (opens in new window).

Now, check your understanding of special pricing issues.

Practice Question