Question Tag: Machine Hire vs Buy

A company has been asked to provide a quotation for an engineering project that will
take one year to complete. An analysis of the project has already been completed and
the following resource requirements have been identified:

(i)
A specialised machine will be required for a total of 10 weeks. Two of these
weeks are at the start of the project and three of them are at the end. The
machine could be hired from a reputable supplier, who would guarantee its
availability when it is required, for ₦40,000 per week. Alternatively it could be
purchased at a cost of ₦2,500,000. If it was purchased, it could be sold in one
year‟s time for ₦1,500,000. If the machine was purchased, it could be hired out
to other companies for ₦25,000 per week and it is believed that it would be
hired out for a total of 30 weeks.
(ii)
The machine has a running cost of ₦7,200 per week. This cost is incurred by
the user of the machine.
(iii)
It is the company‟s policy to depreciate non-current assets by 25% per year on
a reducing balance basis.
(iv)
Skilled labour would be required for a total of 9,000 hours during the year.
The labour required could be recruited at an hourly rate of ₦120. Alternatively
some of the employees currently working on other projects within the company
could be transferred to this project. The hourly rate is ₦100 per hour. If these
existing employees were to be transferred to this project, replacement will be
needed on the existing project work. Replacements on the existing project
work would cost ₦110 per hour.
(v)
Unskilled labour would be required for a total of 12,000 hours during the year.
These employees would need to be recruited on a one year contract at a cost of
₦80 per hour.
(vi)
The project would need to be supervised and it is estimated that there would
be a total of 500 hours of supervision required during the year. One of the
existing supervisors could undertake this work, but will require a total of 300
hours overtime during the year to carry out the supervision on this project as
well as his existing duties. The supervisor earns a salary of ₦500,000 per year
for working 2,000 hours and is not paid for overtime work. If this project goes
ahead, the supervisor will be paid a bonus of ₦5,000, which would not be paid
if the project is not undertaken.

(vii)
The direct materials required for the project are as follows:
Material A
The total amount required for the project would have to be purchased at a cost
of ₦150,000.

Material B
The total quantity required would be 10,000 square metres. The company
purchased 25,000 square metres of this material for a project two years ago at
a total cost of ₦1,000,000. The earlier project used 20,000 square metres of the
material and the remainder is currently held in inventory. The company does
not foresee any other use for this material in the future and could sell it for
₦20 per square metre. The current purchase price of the material is ₦50 per
square metre.

(viii)
The company has already incurred expenditure of ₦250,000 in analysing the
resource requirements of the project.

(ix)
It is the company‟s policy to attribute overhead costs to projects using an
absorption rate of 40% of prime costs.

(x)
It is the company‟s policy to add a 25% profit mark-up to total costs when
setting its prices.

Required:

a.
Prepare a statement that shows the relevant cost of the project. For each of the
resources indicated in notes (1) to (10) you must clearly explain the reason for
the cost value that you have used.

Ignore the time value of money and taxation.

(20 Marks)

b.
Assume that:
(i)
The company used your calculations as the basis of the quotation and
added ₦1,250,000 for profit.
(ii)
All costs incurred were the same as forecast.

Explain why the financial profit reports at the end of the year would not show a
profit of ₦1,250,000 for the engineering project. (4 Marks)

c.
Explain why contribution margin theory is used as a basis for providing
information relevant to decision making.

(2 Marks)

d.
Explain the relevance of opportunity costs in decision making.

(4 Marks)