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.

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:

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:

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.