What Las Vegas Conventions Teach Us About Relevant Costs and Special Orders
It’s July of 2021, and The Wall Street Journal reports that big Las Vegas Mega-Conventions are making a comeback. Many industries host conventions in Sin City, and these events can lead to large orders and new business relationships.
But here’s the real question: Is the new business gained at a convention profitable? Specifically, what price should you charge on a special order to generate a reasonable profit? Special orders are priced differently, because some of the firm’s costs no longer apply.
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Pricing a special order
Let’s assume that your business manufactures outdoor sporting goods and clothing. You’re sweating it out at a Las Vegas Trade show for retailers, and a potential customer wants to buy a large order of Tundra Tough Hiking Shorts. Here are the details:
Tundra Tough Shorts: 2021 Price and Cost Per Unit Budget
Sale Price: $100
Direct Material
StretchAll Cotton $50
Metal, plastic inserts $10
Direct Labor
Cutting, sewing $20
Total Direct Costs $80
Indirect Costs $5
(Overhead)
Total Costs $85
Profit per unit $15 (15%)
Direct costs (material and labor) are costs that can be directly traced to each pair of shorts. Overhead, or indirect costs, cannot be traced to a product. Instead, overhead costs are allocated, based on a level of activity. Direct labor hours worked or machine hours are often used to allocate overhead.
Why a lower price can still be profitable
If you receive an order at the end of the month, many of your indirect costs are already covered. Assume that you’re at the trade show on July 27th (man, it’s hot in Vegas in July). You’ve already paid the July lease on the factory, July utility costs, and repair and maintenance on machinery. You prior July production paid these costs.
The result?
You don’t have to allocate indirect costs for the special order- they’re already paid for in July. All you need to charge are the relevant costs of production.
What, exactly, is a relevant cost?
Understanding relevant costs
A relevant cost changes, based on a decision you make in your business.
I’ve always used the example of a commercial flight that is leaving in 15 minutes. The airline’s costs are nearly all sunk costs- costs that cannot be changed. That includes fuel, labor costs for the crew, gate fees- even the cost of drinks on the flight.
If a passenger buys a ticket at the last minute, none of the sunk costs are relevant when deciding a price for the ticket. The only relevant costs are labor costs needed to store luggage, and that Diet Coke during the flight. Everything else has already been paid.
When you accept a special order (or last minute order), only consider the relevant costs to fill the order. You can take on more business, charge less, and still generate a profit.
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Good luck!
Ken Boyd
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
(email) ken@stltest.net
(website and blog) https://www.accountingaccidentally.com/