Question

Exercise 1

The production department of Alpha Ltd. normally operates at a capacity of 5 000 direct labor hours (DLH) per production period. In the coming production period (April-May) orders equivalent to only 3 000 DLH have been received. Even though direct labor is hired/paid on an hourly basis, Alpha Ltd. wants to deploy the available 2 000 DLH and considers two alternatives:

First alternative: advancing the production of an anticipated future order that consumes             2 000 DLH (delivery date end of July). Alpha Ltd. expects a very busy period in June-July, so by producing the future order in April-May, the production department avoids performing and paying 2 000 DLH in overtime in June-July. Overtime is paid by adding a 30% premium on the normal wage of 4 EUR/DLH. The longer storage of the early production in Alpha’s inventory does not cause incremental costs.

Second alternative: deploying the 2 000 DLH by accepting an exceptional, one-time order to be produced in April-May. The following resources are needed to produce the order:

Materials:

960kg of resource X. Resource X is currently in inventory with an average cost of 3.02 EUR/kg (average book value/kg). The current market price (replacement cost) of resource X equals 3.10 EUR/kg. Resource X is commonly used in the production department.

570kg of resource Y. Resource Y is currently in inventory with an average cost of 5.26 EUR/kg (average book value/kg). The replacement cost is 5.85 EUR/kg. Resource Y has no other application, but can be sold at 2.30 EUR/kg.

Other resources. These resources are not in inventory but can be bought at 3 360 EUR.

Direct labor: 2 200 DLH

Indirect costs (e.g. depreciation machines, maintenance machines, electricity costs,…) are attributed to the different departments at 6 EUR/DLH. 40% of these indirect costs are variable, and consequently really vary with the number of DLH performed (e.g. if DLH are performed, machines run and maintenance and electricity costs are incurred). The other 60% of the indirect costs are fixed (e.g. depreciation costs).

QUESTIONS:

Determine the one-time offer’s minimal price that allows Alpha to increase profit in comparison with the other alternative (do not consider the possible interest costs and revenues as a result of different cash flow timings).

(Theory) Give, based on this specific situation, a description of the following concepts:

Sunk costs, b. Opportunity costs, c. Incremental costs

Answer 1

We have to find out the minimal price of one time offer so that alpha will not loose on the part of profit in comparison to other alternative that is by not applying the labour to overtime work.

In such a case we are also required to consider opportunity cost of first alternative i.e. overtime premium on DLH of 2000.

Opportunity cost = 2000x4x30% = 2400

Calculation of minimal price for one time offer

Resource x (960kgx3.10*)	2976
Resource y (570kgx2.3**)	1311
Other material	3360
Direct labour (2200x4)	8800
Variable indirect cost (2200x2.4)	5280
Opportunity cost (from above)	2400
Minimal price	24127

* Resource x is currently in inventory and is regularly used in the production thus any use of it will require an immediate replacement with the new quantity and thus replacement cost is taken as cost of resource x

Average cost of inventory shall be ignored as it is sunk cost and ignored from decision making perspective.

** Resource y is also in stock but is not used and has no use except for resale thus resale value of 2.30 is considered as value of resource y.

It is to be noted that for decision making perspective only variable cost is considered and fixed cost is ignored because fixed cost will continue to occur whether or not we choose any alternative thus it is totally ignored from decision making perspective.

Sunk cost => sunk cost is the cost which has already been in urred or the obligation of which has already been decided. These costs are ignored for decision making purpose. For eg. To find out the demand of a product that the company is contemplating to produce, it has undertaken market survey for 2000, now this 2000 is a sunk cost as it has already been incurred and will not have any bearing on decision to make product.

Opportunity cost => It is the value that the company has foregone by not accepting the next best alternative by choosing a particular alternative. For eg. Businessman decided to do a business by investing a capital of 10000. Bank interest rates are 4% here if businessman by deciding to do business has foregone int. That he could have earned from bank int. I.e.10000x4%=400.

Incremental cost => It is the cost which is incurred only when we choose a particular alternative. For eg. If we make a product we have to take machinery on rent for 2000 here incremental cost = 2000.