Short Term Decision Making - Relevant Cost and Opportunity Cost Q.1 k!ar "ngineering Company
Akbar Engineering Company is considering to undertake a one year contract contract to produce and supply part W to Nadir Manufacturing Company. only. The machine 1 The contract will utilie an e!isting machine suitable for this work only. cost "s. #$%&%%% fi'e years ago and has a book 'alue of "s. $%&%%%. the machine could be sold now for "s. (%&%%% or in one year)s time for "s. 1%&%%%. # *our types of material would be needed for the contract as follows+
,nits in "e-uired Material stock for contract W 1&#%% %% / #%% 1&1%% 0 &%%% %% 2 1&(%% #&3%% W and 2 are ar e regular in use within the company. company.
Cost price 1( ( $ 1(
Current price 1$ #( ( #%
study for specification and designing was carried out # month ago A research study costing "s. #$&%%%. 3 The labour re-uirement and rates will be as follows+ skilled 3%% hrs 5 "s. $ per hour 6emi skilled %% hrs 5 "s. % per hour ,nskilled #%% hrs 5 "s. #% per hour At present skilled labour are in shortage so so the company will will make it necessary for the skilled labours to be di'erted from the other work on which a contribution margin of "s. 3$ per hour is earned& net of wages cost. The firm currently has a surplus of semi skilled workers paid at full rate but doing unskilled work. The labour concerned could be transferred to pro'ide sufficient labour for this contract and would be replaced by unskilled workers. $ 7'erhead cost are allocated to this contract 5 "s. 1( per skilled labour hours as
follows+
*i!ed 5 "s. 1.%%
8ariable 5 "s. $.%%
This contract would re-uire the ser'ices of an e!isting manager who would be paid
"s. 1#&%%% per month. 9f not re-uired for this contract he would be made redundant and would recei'e "s. &%%% per month under ser'ice agreement. : The undertaking of this contract is e!pected to cause production of an e!isting product
;ango& to fall by &%%% units. The profitability of ;ango is as follows+ 6ales price 8ariable cost (%.%% *i!ed Cost 1$.%%
1#%.%% 4$.%% #$.%%
Re#uired$
Calculate the minimum price of the contract where there will be no loss no profit. pr ofit. (Answer - Rs. 427,500)
"esale 'alue 1# #1 14
Q.% nother Customer
A company has been making a machine for a customer customer but the customer has& howe'er& howe'er& gone into li-uidation and there are no prospects that any money will be obtained from the winding up of his company and the incomplete machine can be sold at "s. #&%%% only. only. Cost incurred to
abour is in short supply and if the machine is not finished& the workforce would be switched o'er to another ?ob& which earns "s. %&%%% in re'enue& and incurs direct cost @ not including direct labour= "s. 1#&%%%& and absorbs fi!ed o'erhead of "s. (&%%%. c= Consultancy fees& "s. 3&%%%. 9f the work is not completed& the consultant)s contract would be cancelled at a cost of "s. 1&$%%. d= eneral o'erheads of "s. 1%&$%% would be added to the cost of the remaining work. Re#uired$
6hould the new customer)s offer be acceptedB
(Answer - Net benefit for accepting new order Rs. 9,500)
Q.& 'u!lishing Company
0ou are the management accountant of a publishing and printing company which has been asked for the production of a programme for the winter cricket season. The work would be carried out in addition to the normal work of the company. company. ;ecause of the e!isting commitments& some weekend working would would be re-uired to complete the printing of the programme. A trainee accountant has produced the following cost estimate based upon the resources re-uired as specified by the production manager. irect material < paper @book 'alue= ink @purchase price= irect labour < skilled #$% hours 5 3% unskilled #$% hours 5 $ 'ariable o'erhead $% hours 5 3% Drinting press depreciation #%% hours 5 #$ *i!ed production costs $% hours 5 % Estimating department costs
0our are aware that considerable publicity could be obtained for the company if you are able to win this order and the price -uoted must be 'ery competiti'e. The following notes are rele'ant to the cost estimate abo'e+ 1 The paper to be used is is currently in stock at a 'alue of "s. $%&%%%. 9t is of an unusual colour which has not been used for some time. The replacement price of the paper is "s. (%&%%%. Whilst the scrap 'alue of that in stock is "s. #$&%%%. The production manager does not foresee any alternati'e use for the paper if it is not used for the programme. # The inks re-uired are not held in stock. They would would ha'e to be purchased
"s. $%&%%% #3&%%% 1%&%%% &$%% 13&%%% $&%%% #1&%%% 3&%%% 11&$%%
3
$
: (
in bulk at a cost of "s. %&%%%. (% of the ink purchased would be used in printing the programme. No other use is foreseen for the remainder. 6killed direct labour is in short supple& and to accommodate the printing of the programmes& $% of the time re-uired would be worked at weekends for which a premium of #$ abo'e the normal hourly rate is paid. The normal hourly rate is "s. 3% per hour. ,nskilled labour is presently under
Re#uired$
a Drepare a re'ised cost estimate using the opportunity cost approach& showing clearly the minimum price that the company should accept for the order. i'e reasons for each resource 'aluation in your cost estimate. b E!plain why contribution theory is used as a basis for pro'iding information rele'ant to decision making. c E!plain the rele'ance of opportunity costs in decision making. (Answer - Rs. 88,875)
Q.( Three lternatives )*CM' May %++,
;row >td. 9s a company that has in stock some materials of type /0 that cost "s. :$&%%% but these materials are now obsolete and has a scrap 'alue of only "s. #1&%%%. 7ther than selling the material for scrap& there are only two alternati'e uses for them. Alternati'e 1+ Con'ert the obsolete materials into a specialised product& which would re-uire the following additional work and materials+ Material A Material ; irect labour $&%%% hors unskilled $&%%% hors semiskilled $&%%% hors highly skilled
%% 1&%%%
units units
Total 1$&%%% hours
E!tra selling and deli'ery e!penses E!tra ad'ertising e!penses
#:&%%% 1(&%%%
The con'ersion would produce 4%% units of saleable products& and these could be sold
for "s. %% per unit Material A is already in stock and is widely used within the firm. Although present stocks together with orders already planned will be sufficient to facilitate normal acti'ity& any e!tra material used by adopting this alternati'e will necessitate such materials being replaced immediately. Material ; is also in stock& but it is unlikely that any additional supplies can be obtained for some considerable time because of an industrial dispute. At the present time material ; is normally used in the production of Droduct 2& which sells at "s. 4% per unit and incur total 'ariable cost @e!cluding material ;= of "s. #1% per unit. Each unit of product 2 uses four units of Material ;. Material A Material ; "s. "s. Ac-uisition cost at time of purchase 1%% per unit 1% per unit Net realiable 'alue ($ per unit 1( per unit "eplacement cost 4% per unit Alternati'e #+ Adopting the obsolete materials for use as a substitute for a subtd. The 1&%%% units re-uired would be a'ailable from stocks& but would be produced as e!tra production. The standard cost per unit of material C would be as follows+ "s. irect labour& hours unskilled labour "aw materials 8ariable o'erhead& hours at "e. 1 *i!ed o'erhead& hours at "s.
The wages rates and o'erhead reco'ery rates for ;rown >td are+ 8ariable o'erhead "s. 1 per direct labour hour *i!ed o'erhead "s. per direct labour hour ,nskilled labour "s. per direct labour hour 6emiskilled labour "s. 3 per direct labour hour Fighly skilled labour "s. $ per direct labour hour The unskilled labour is employed on a casual basis& and sufficient labour can be
1( 1 1( $$
ac-uired to e!actly meet the production re-uirements. 6emiskilled labour is part of the permanent labour force& but the company has temporary e!cess supply of this type of labour at the present time. Fighly skilled labour is in short supply and cannot be increased significantly in the short termG this labour is presently engaged in meeting the demand for product >& which re-uires 3 hours of highly skilled labour. The CM from sale of one unit of product > is "s. #3. Re#uired$
Drepare and present cost information& ad'ising whether the stocks of material /0 should be sold& con'erted into specialied product @alternati'e 1= or adapted for use a substitute for a sub
Q
*aal 9ndustries >imited is currently negotiating a contract to supply its products to Himited belie'es that the offered price is too low. Fowe'er& the management has asked you to reabour+ 6killed @i'= 3&%$%&%%% ,nskilled @'= #&#$%&%%% 6uper'isory @'i= (1%&%%% 7'erheads @'ii= (&$%%&%%% Total cost #%&:1%&%%% 0ou ha'e analysed the situation and gathered the following information+ @i= Material / is a'ailable in stock. 9t has not been used for a long time because a substitute is currently a'ailable at #% less than the cost of /. @ii= Material 0 was ordered for another contract but is no longer re-uired. 9ts net realiable 'alue is "s. 1&3:%&%%%. @iii= Material 2 is not in stock. @i'= 6killed labour can work on other contracts which are presently operated by semiskilled labour who ha'e been hired on temporary basis at a cost of "s. #$&%%% per month. The company will need to gi'e them a notice of % days before terminating their ser'ices. @'= ,nskilled labour will ha'e to be hired for this contract. @'i= Two new super'isors will be hired for this contract at "s. 1$&%%% per month. The present super'isors will remain employed whether the contract is accepted or not. @'ii= These include fi!ed o'erheads absorbed at the rate of 1%% of skilled labour. *i!ed production o'erheads of "s. (:$&%%% which would only be incurred if the contract is accepted& ha'e been included for determining the abo'e fi!ed o'erhead absorption rate. Re#uired$
Drepare a re'ised statement of estimated costs using the opportunity cost approach& for the
management of *aal 9ndustries and state whether the contract should be accepted or not. (Answer - #es sa!ing Rs. 2.57 $iion)
Q/
6un *ashions @D't.= >imited& a chain of retail garments store& has planned to introduce a new fancy dress for babies at all its se'en outlets in the country. The company is also considering to introduce a matching crown scarf and handbag with the new dress. Currently they are e!pecting to sell 1$&%%% dresses in the first si! months but the management feels that this sale can be increased by % if matching crown scarf and handbag are marketed together. The data relating to sales and production of dress& crown scarf and handbag are as follows+ @i= Each dress re-uires three and half meter of cloth which is easily a'ailable in the market at a price of "s. 1%% per meter. Dart of the material left unused can be used to manufacture a crown scarf and handbag. @ii= The cost of cutting the dress& crown scarf and handbag is "s. $& "s. 1$ and "s. #% respecti'ely. @iii= The lefto'er pieces can be sold as under+ I if only the dress is manufactured& "s. #% per dressG I if crown scarf and handbag is also manufactured& "s. $ per set. @i'= The company has a contract with a designer firm at a monthly fee of "s. 1&$%%&%%%. Fowe'er& in the case of handbag and crown scarf& the company will ha'e to pay a one time additional amount of "s. 1$%&%%% to the designer firm. @'= Each handbag will re-uire a metal hook which is a'ailable in the market at "s. 1% per hook. Fowe'er& the company has sufficient number of metal hooks in stock which was purchased at "s. per hook. 9f the company does not opt for the manufacturing of handbags& these hooks can be sold at "s. ( per hook. @'i= The dresses& crown scar'es and handbags are e!pected to be sold according to the following mi!+ Complete set % ress and crown scarf only 1% ress and handbag only #% ress only 1% @'ii= The selling price and 'ariable costs @besides those mentioned abo'e= of each product are as follows+ 6elling Drice per 8ariable Costs unit @"s.= @besides those mentioned abo'e ress Crown scarf Fandbag
#&%%% 3%% $%%
3% of selling price $$ of selling price % of selling price
Re#uired$
Calculate the incremental profit or loss as a result of manufacturing handbags and crown scar'es with the dress. (Answer - Rs. 8,279,700)
Q,
Topa >imited @T>= is the manufacturer of consumer durables. Dearl >imited& one of the ma?or customers& has in'ited T> to bid for a special order of 1$%&%%% units of product ;eta. *ollowing information is a'ailable for the preparation of the bid. @i= Each unit of ;eta re-uires %.$ kilograms @kg= of material JCK. This material is produced internally in batches of #$&%%% kg each& at a 'ariable cost of "s. #%% per kg. The setup cost per
batch is "s. (%&%%%. Material JCK could be sold in the market at a price of "s. ##$ per kg. T> has the capacity to produce 1%%&%%% kg of material JCKG howe'er& the current demand for material JCK in the market is :$&%%% kg. @ii= E'ery 1%% units of product ;eta re-uires 1$% labour hours. Workers are paid at the rate of "s. 4&%%% per month. 9dle labour hours are paid at % of normal rate and T> currently has #%&%%% idle labour hours. The standard working hours per month are fi!ed at #%% hours. @iii= The 'ariable o'erhead application rate is "s. #$ per labour hour. *i!ed o'erheads are estimated at "s. ## million. 9t is estimated that the special order would occupy % of the total capacity. The production capacity of ;eta can be increased up to $% by incurring additional fi!ed o'erheads. The fi!ed o'erhead rate applicable to enhanced capacity would be 1.$ times the current rate. The utilied capacity at current le'el of production is (%. @i'= The normal loss is estimated to be 3 of the input -uantity and is determined at the time of inspection which is carried out when the unit is % complete. Material is added to the process at the beginning while labour and o'erheads are e'enly distributed o'er the process. @'= T> has the policy to earn profit at the rate of #% of the selling price. Re#uired$
Calculate the unit price that T> could bid for the special order to Dearl >imited. ( Ans%299)
Q0
Tychy >imited @T>= is engaged in the manufacture of 6pecialied motors. The company has been asked to pro'ide a -uotation for building a motor for a large te!tile industrial unit in Dun?ab. *ollowing information has been obtained by T>Ls technical manager in a one in production. T> has %% ft of wire for the motor. Wire< would be purchased from a supplier at "s. 1% per kg. The supplier sells a minimum -uantity of % kg per order. Fowe'er& the remaining -uantity of wire< will be of no use to T> after the completion of the contract. The other small components will be purchased from the market at "s. (% per component. @iii= The manufacturing process would re-uire #$% hour s of skilled labour and % machine hours. The skilled workers are paid a guaranteed wage of "s. #% per hour and the current spare capacity a'ailable with T> for such class of workers is 1%% direct labour hours. Fowe'er& additional labour hours may be obtained by either+ I Daying o'ertime at "s. # per hourG or I Firing temporary workers at "s. #1 per hour. These workers would re-uire $ hours of super'ision by A>Ls e!isting super'isor who would be paid o'ertime of "s. #% per hour. The machine on which the motor would be manufactured was leased by T> last year at a monthly rent of "s. $&%%% and it has a spare capacity of 11% hours per month. The 'ariable running cost of the machine is "s. 1$ per hour. @i'= *i!ed o'erheads are absorbed at the rate of "s. #$ per direct labour hour. Re#uired$
Compute the rele'ant cost of producing te!tile motor. i'e brief reasons for the inclusion or e!clusion of any cost from your computation. @1% marks=
Q
The managing director of Darser >td& a small business& is considering undertaking a one
"s. 1 # 3 $
#(&$%% 11&$%% 3&%%% #&%% 1(&%%% 3&%%% 4(&%%
Notes+ 1. irect wages comprise the wages of two employees& particularly skilled in the labour process for this ?ob& who could be transferred from another department to undertake work on the special order. They are fully occupied in their usual depar tment and sub
bank o'erdraft amounting to "s.#%&%%% would be re-uired for the pro?ect duration of three months. The o'erdraft would be repaid at the end of the period. The company uses a cost of capital of #% to appraise pro?ects. The bank o'erdraft rate is 1(. The managing director has heard that& for special orders such as this& rele'ant costing should be used that also incorporates opportunity costs. Fe has approached you to create a re'ised costing schedule based on rele'ant costing principles. Re#uired$
Ad?ust the schedule prepared by the accountant to a rele'ant cost basis& incorporating appropriate opportunity costs. (Ans 88,200)
Q 1+
M is the holding company of a number of companies within the engineering sector. 7ne of these subsidiaries is DO" which specialises in building machines for manufacturing companies. DO" uses absorption costing as the basis of its routine accounting system for profit reporting. DO" is currently operating at 4% of its a'ailable capacity& and has been in'ited by an e!ternal manufacturing company& to tender for the manufacture of a bespoke machine. 9f DO"Ls tender is accepted by the manufacturing company then it is likely that another company within the M group will be able to obtain work in the future ser'icing the machine. As a result& the ;oard of irectors of M are keen to win the tender for the machine and are prepared to accept a price from the manufacturing company that is based on the rele'ant costs of building the machine. An engineer from DO" has already met with the manufacturing company to determine the specification of the machine and he has worked with a non<-ualified accountant from DO" to determine the following cost estimate for the machine. Note P Engineering specification 1 1&$%% irect material A # 1&%%% irect Material ; #&$%% Components 3 &%%% irect >abour $ 1#&$%% 6uper'ision $% Machine hire : #&$%% 7'erhead costs ( $&$%% Total 41&($% 2OT"S
1. The engineer that would be in charge of the pro?ect to build the machine has already met with the manufacturing company& and subse-uently prepared the specification for the machine. This has taken three days of his time and his salary and related costs are P$%% per day. The meeting with the manufacturing company only took place because of this potential workG no other matters were discussed at the meeting. #. The machine would re-uire 1%&%%% s-uare metres of Material A. This material is regularly used by DO". There is currently 1$&%%% s-uare metres in in'entory& 1%&%%% s-uare metres were bought for P per s-uare metre and the remainder were bought for P% per s-uare metre. DO" uses the weighted a'erage basis to 'alue its in'entory. The current market price of Material A is P: per s-uare metre& and the in'entory could be sold for P$% per s-uare metre.
. The machine would also re-uire #$% metre lengths of Material ;. This is not a material that is regularly used by DO" and it would ha'e to be purchased specifically for this work. The current market price is P1% per metre length& but the sole supplier of this material has a minimum order sie of %% metre lengths. DO" does not foresee any future use of any unused lengths of Material ;& and e!pects that the net re'enue from its sale would be negligible. 3. The machine would re-uire $%% components. The components could be produced by FH& another company within the M group. The direct costs to FH of producing each component is P(& and normal transfer pricing policy within the M group is to add a $% mark up to the direct cost to determine the transfer price. FH has unused capacity which would allow them to produce $% components& but thereafter any more components could only be produced by reducing the 'olume of other components that are currently sold to the e!ternal market. These other components& although different& re-uire the same machine time per unit as those re-uired by DO"& ha'e a direct cost of P per component and currently are sold for P4 each. Alternati'ely DO" can buy the components from the e!ternal market for P13 each. $. The machine will re-uire 1%%% hours of skilled labour. The current market rate for engineers with the appropriate skills is P1$ per hour. DO" currently employs engineers that ha'e the necessary skills at a cost of P1#.$% per hour& but they do not ha'e any spare capacity. They could be transferred from their e!isting duties if temporary replacements were to be engaged at a cost of P13 per hour. . The pro?ect would be super'ised by a senior engineer who currently works 1$% hours per month and is paid an annual salary of P3#&%%%. The pro?ect is e!pected to take a total of one month to complete& and if it goes ahead is likely to take up 1% of the super'isorLs time during that month. 9f necessary the super'isor will work o'ertime which is unpaid. :. 9t will be necessary to hire specialist machine for part of the pro?ect. 9n total the pro?ect will re-uire the machine for $ days but it is difficult to predict e!actly which fi'e days the machine will be re-uired within the o'erall pro?ect time of one month. 7ne option is to hire the machine for the entire month at a cost of P$&%%% and then sub
@a= 0ou are employed as assistant Management Accountant of the M group. *or each of the resource items identified you are to+ @i= discuss the basis of the 'aluation pro'ided for each item @ii= discuss whether or not you agree with the 'aluation pro'ided in the conte!t of the proposed tender @iii= prepare a re'ised schedule of rele'ant costs for the tender document on behalf of the M group. @1$ marks= @b= Assume that DO" successfully wins the bid to build the machine for a selling price of P1%%&%%% and that the costs incurred are as e!pected. iscuss the conflict that will arise between the profit e!pected from the pro?ect by the ;oard of M on a rele'ant cost basis and the pro?ect profit
that will be reported to them by DO" using its routine accounting practices. ,se at least two specific e!amples from the bid to e!plain the conflict that you discuss. @c= iscuss two non
@$ marks= @$ marks=
@Marks+13=
@Marks+1=
