Question

Ennerdale Ltd has been asked to quote a price for a one-off contract. The company's management accountant has asked for your advice on the relevant costs for the contract. The following information is available:

Materials

The contract requires 3,000 kg of material K, which is a material used regularly by the company in other production. The company has 2,000 kg of material K currently in stock which has been purchased last month for a total cost of $19,600. Since then the price per kilogram for material K has increased by 5%.

The contract also requires 200 kg of material L. There are 250 kg of material L in stock which are not required for normal production. This material originally cost a total of $3,125. If not used on this contract, the stock of material L would be sold for $11 per kg.

Labour

The contract requires 800 hours of skilled labour. Skilled labour is paid $9.50 per hour. There is a shortage of skilled labour and all the available skilled labour is fully employed in the company in the manufacture of product P. The following information relates to product P:

	$ per unit	$ per unit
Selling price		100
Less
Skilled labour	38
Other variable costs	22
		(60)
		40

  

Required:

(a) Prepare calculations showing the total relevant costs for making a decision about the contract in respect of the following cost elements:

(i) materials K and L; and

(ii) Skilled labous

(b) Explain how you would decide which over head costs would be relevant in the financial appraisal of the contract.

Answer 1

• All working forms part of the answer
• Answer (a)

Relevant costs of Material K

Required is 3000 kgs. Already available is 2000kgs.
Hence, the cost of 2000 kgs, which is $19600 is irrelevant.
Cost per kg was 19600/2000 = $9.8 per kg has now gone up by 5%.

New cost per kg = 9.8 x 1.05 = $10.29
Cost of remaining 1000 kgs= 1000 kgs x $10.29 = $10,290

Relevant cost of Material K = $10,290

Relevant costs of Material L

Required 200 kgs, already available 250 kgs. Hence not required to purchase.

However if 200 kgs were sold instead of being used, it would earn company $11 per kgs.
Hence, opportunity cost considered for decision making will be $11 x 200 Kgs = $2200

Relevant cost of Material L = $2,200

Relevant cost of Labour

800 hours required.

If 800 hours used, company will not be able to produce product P. Hence, its contribution will be lost. One unit of P takes 4 hours of skilled labour ($38/$9.5 per hour). Hence, in 800 hours, 200 units of P would have been produced. Total contribution lost would be 200 units x $40 = $8000

Labour cost = 800 hours x $9.5 per hour = $7,600

Hence, total relevant cost for labor = 7600 + 8000 = $15,600

• Answer (b)

In deciding whether overhead is relevant in the financial appraisal of a contract, we see if that particular overhead is avoidable in nature or not. If its avoidable, it is relevant, other wise, it is irrelevant or sunk cost.