Identifying Relevant Costs in Accepting an Order

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  • 0:04 Types of Special Orders
  • 0:52 Relevant Costs
  • 1:24 Variable Costs
  • 2:21 Fixed Costs
  • 2:53 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

Orders often come with strings attached. In this lesson, we'll look at the relevant costs in accepting an order, seeing how much the difference between fixed and variable costs matters.

Types of Special Orders

From time to time, your customers may ask you to produce a special order. A special order is best defined as any order made outside of usual parameters. This can include a wide range of types of orders. For example, a customer may ask for your widget firm to print their logos on the widgets, or they may ask for the widgets to be ready a week earlier than usual. These types of orders often command a higher price, but a special order doesn't always have to come at a premium. It could just be that a customer has asked for an order to be ready at a lower price. In this lesson, we'll look at the relevant costs of taking a special order, no matter the price. Keep in mind that a relevant cost is a cost directly incurred by a given activity. We'll then look at examples to see how these relevant costs change and how this affects the price you accept.

Relevant Costs

Remember that all of your relevant costs can be divided into two categories. First of all, there are fixed costs. These are those costs that are there no matter how many units that you sell, although a change to the process could raise fixed costs. Property taxes, the manager's salary, and machinery are all fixed costs. Meanwhile, there are also variable costs. Variable costs are those costs that change depending on how many units are manufactured. This includes raw materials, hourly or per unit wages, and overhead like electricity.

Variable Costs

As a general rule, companies should never take a price that is lower than their variable cost per unit, plus some markup. Now that may sound strange, but let me explain. Let's say you've just invested in an ice cream truck business. The truck itself is the fixed cost, while each ice cream cone has a variable cost. You should always charge more than the variable cost. However, no one would buy your ice cream if you priced your first ice cream cone as the variable cost of one cone plus the fixed cost of the whole truck! Instead, you've got to break up the fixed cost over time.

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