Question

Mr. Lee, CEO of a company has been asked to quote a price for a special contract. The customer is not a current customer of the company, but Mr. Lee wants to try and win the contract as he believes that this may lead to more contracts in the future. As a result, he intends to quote a competitive price for the contract. The following information should be considered:

1. One of the company’s salesmen has been to visit the customer, to give them a presentation about the company’s product, together with a complimentary lunch, the costs of which totaled $1,000.

2. The contract would require 12,000 square meters of Material A. This material is regularly used by the company for producing a profitable product. There is currently 15,000 square meters in inventory, which was bought for $13 per square meters. The current market price of Material A is $13.5 per square meter, and the inventory could be sold for $12.5 per square meter.

3. The contract would require 1,500 square meters of Material B. 1,000 square meters is in inventory at a cost of $5 per square meter. There is no alternative use of the material and can be sold for $3 per square meter. The current market price of Material B is $10 per square meter.

4. The contract would require 300 litres of Material C. This is not a material that is regularly used by the company and there are 600 litres of this material in inventory. The current market price is $10 per litre. It is dangerous and if not used in this contract will have to be disposed of at a cost of $30 per litre.

5. The contract would require 900 hours of skilled labor that is hard to recruit. The skilled labour will be transferred to the contract from a production department. The hourly rate is $80 per hour. At a recent meeting, the production department manager claimed that if the men were returned to him they could generates sales of $200,000. The material costs for the sales will be $50,000.

6. The contract would utilizes a special equipment which cost $18,000 that was purchased two years ago. The net book value is $6,000. This special equipment is currently not used for any production and can be disposed now at a net realizable value of $9,000. If used in the contract, the net realizable value after use is estimated to be $2,000.

7. The contract would be supervised by a senior engineer who currently works 150 hours per month and is paid an annual salary of $720,000. The contract is expected to take one month to complete, and if it goes ahead is likely to take up 10% of the supervisor’s time during that month. If necessary the supervisor will work overtime which is unpaid.

8. This is based on 500 machine hours for the contract at a predetermined fixed overhead rate of $20 per machine hour.

Required:

a. You are employed as assistant Management Accountant by Mr. Lee. For each of the items identified you are to:

(1) discuss whether or not you agree with the valuation provide in the proposed tender

(2) prepare a revised schedule of relevant costs for the tender and determine the minimum price .

b. From a decision-making point of view, should joint costs be allocated among joint products? What guideline should be used in determining whether a joint product should be sold at the split-off point or processed further?

Answer 1

Answer (1)

In this special contract, the customer is not a current customer of the company, but Mr. Lee wants to try and win the contract as he believes that this may lead to more contracts in the future. Thus in the proposed tender, the valuation should be done on the basis of relevant cost incurred by the company so that the company is able to quote a competitive price.

Answer (2)

A revised schedule of relevant costs for the tender is:

Particulars	Calculation	Amount in $
Material
Material A	12000 sqm*$13.5	162,000
Material B	1000 sqm * $3 500 sqm * $10	3,000 5,000
Material C	300 litres * $30	(9,000)
Skilled labor		78,000
Special equipment		7,000
Relevant cost		246,000

Working Notes

1. The cost incurred when salesman went to give presentation is a sunk cost, and hence will not be included in cost above.

2. Material A is regularly used by the company for producing a profitable product. Hence it will be valued at current market price.

3. The contract would require 1,500 square meters of Material B. 1,000 square meters of material B is in inventory There is no alternative use of the material B and can be sold for $3 per square meter. Thus it leads to opportunity cost of $3,000 (1,000 sqm*$3). Further, 500 square meters would be bought at the current market price of $10 per square meter.

4. The contract would require 300 litres of Material C. This is not a material that is regularly used by the company and there are 600 litres of this material in inventory. It is dangerous and if not used in this contract will have to be disposed of at a cost of $30 per litre, therefore the contract saved the cost.

5. The contract would require 900 hours of skilled labor that is hard to recruit. The skilled labour will be transferred to the contract from a production department. The hourly rate is $80 per hour. At a recent meeting, the production department manager claimed that if the men were returned to him they could generates sales of $200,000. The material costs for the sales will be $50,000. Thus, because of the contract , company lost contribution of :

Particulars	Calculation	Amount in $
Sales		200,000
(-) Material Cost		(50,000)
(-) Labour Cost	900 hours * $80	(72,000)
Contribution lost		78,000

6. The contract would utilizes a special equipment which cost $18,000 that was purchased two years ago. The net book value is $6,000. This special equipment is currently not used for any production and can be disposed now at a net realizable value of $9,000. If used in the contract, the net realizable value after use is estimated to be $2,000. Thus, if the contract is executed, company will lose $7,000.

7. The contract would be supervised by a senior engineer who currently works 150 hours per month and is paid an annual salary of $720,000. The contract is expected to take one month to complete, and if it goes ahead is likely to take up 10% of the supervisor’s time during that month. If necessary the supervisor will work overtime which is unpaid. If the contract is taken, then the supervisor will have to work overtime which is unpaid, thus no relevant cost is incurred.

8. Contract is based on 500 machine hours payable at a predetermined fixed overhead rate of $20 per machine hour. It is fixed and hence not relevant.

Answer (3)

Joint cost is the manufacturing cost incurred on a joint production process which takes common inputs but simultaneously produces multiple products called joint-products e.g. processing of crude oil simultaneously yields gasoline, diesel, jet fuel, lubricants and other products. These products incur undifferentiated joint costs until a split-off point, after which each product incurs separate processing. Prior to the split-off point, costs can only be allocated to the joint products. From a decision-making point of view, joint costs should be allocated among joint products as Joint costs are common to the processing of joint products or by-products upto the point of separation. In other words, joint costs are allocable to two or more products produced from same raw material or the same process.

When facing the choice of selling or processing further, the company must determine the revenues that would be received if the product is sold at the split-off point versus the net revenues that would be received if the product is processed further. This requires knowing the additional costs of further processing. In general, if the differential revenue from further processing is greater than the differential costs, then it will be profitable to process a joint product after the split-off point. Any costs incurred prior to the split-off point are irrelevant to the decision to process further as those are sunk costs; only future costs are relevant costs. As long as the incremental revenue from further processing exceeds the incremental costs of further processing, the product should be processed further. These are the guidelines that should be used in determining whether a joint product should be sold at the split-off point or processed further are: