- 20 Marks
Question
Semenhyia Ltd is involved in the design and manufacture of custom-built factory equipment. The company has just received an enquiry about the supply of 10 machines from one of their regular clients, Kukua Ltd.
Kukua Ltd has informed the company that the maximum price they are willing to pay is GH¢5,200 per machine. The order would need to be completed within two weeks.
The following details relate to the production of the machines:
i) Materials per machine:
- 10 units of Material A, which is used regularly by the company. The company has 120 units of Material A in stock, which originally cost GH¢120 per unit. The replacement cost of Material A is 20% higher than the original price.
- 5 units of Material B. The company has 40 units of Material B in stock, as it was purchased a few years ago for use in the production of other equipment, which the company no longer produces. If this material is not used in the production of this order, it would never be used again. The original purchase price for Material B was GH¢190 per unit. The replacement cost is GH¢150 per unit, and the net realizable value is GH¢130 per unit.
- 3 units of Material C. This material is used regularly and usually costs GH¢85 per unit. However, the earliest delivery time for new stock from the regular supplier is three weeks. An alternative supplier could deliver immediately but would charge GH¢90 per unit. Semenhyia Ltd has 600 units in stock, but 580 units are required to complete other orders over the next two weeks.
ii) Labour hours per machine:
- 12 skilled labour hours, paid GH¢20 per hour. Skilled workers are part of the permanent workforce, with 125 surplus skilled hours available per month. Skilled workers are paid time and a half for overtime.
- 22 unskilled labour hours, paid GH¢15 per hour, employed on a casual basis.
iii) Supervision: A supervisor currently paid GH¢56,500 per annum will oversee the project, but a replacement will be hired for the duration of the contract at a cost of GH¢8,500.
iv) Machine hours: Each machine requires 18 hours of processing time on factory equipment. If the order is not accepted, the equipment would be subcontracted to Fimi Ltd for a contribution of GH¢70 per hour.
v) Depreciation: The depreciation charge for using the equipment for this order would be GH¢4,000.
vi) Overheads: Overheads are absorbed at a rate of GH¢35 per skilled labour hour.
vii) Estimate costs: The planning department has incurred costs to date of GH¢600.
Required:
a) Explain relevant cost and state TWO (2) examples of relevant cost in short-term decision-making. (3 marks)
b) Determine, using relevant costing principles, whether or not Semenhyia Ltd should undertake the contract. Your answer must include an explanation for the inclusion or exclusion of each of the above points. (13 marks)
c) Distinguish between “marginal cost” and “differential cost”. (4 marks)
Answer
a) Relevant Cost:
A relevant cost is a future cost that differs between alternatives. It is a cost that will only be incurred or avoided depending on the decision taken. Relevant costs are crucial in short-term decision-making, as they help assess the financial impact of each option.
Examples of Relevant Costs in Short-Term Decision-Making:
- Future cash flows: Any future cost directly affected by a decision.
- Opportunity costs: The benefit lost by choosing one alternative over another.
(3 marks)
b) Relevant Costing for the Contract:
| Cost Item | Calculation | Relevant Cost (GH¢) | Explanation |
|---|---|---|---|
| Material A | 10 machines × 10 units × GH¢144 | 14,400 | Regularly used material; valued at replacement cost (GH¢120 + 20% increase). |
| Material B | (40 units × GH¢130) + (10 units × GH¢150) | 6,700 | Material B will never be used again; valued at net realizable value and replacement cost. |
| Material C | (10 units × GH¢90) + (20 units × GH¢85) | 2,600 | 10 units must be purchased from an alternative supplier at GH¢90; remaining units can be replaced later. |
| Skilled Labour | No additional cost for regular hours | 0 | Surplus hours cover the job; no extra cost for regular skilled labour. |
| Unskilled Labour | 10 machines × 22 hours × GH¢15 | 3,300 | Unskilled labour is hired on a casual basis; cost is directly relevant. |
| Supervision | Fixed cost | 8,500 | Only the cost of hiring the replacement supervisor is relevant. |
| Machine Opportunity Cost | 18 hours × 10 machines × GH¢70 | 12,600 | The opportunity cost of not subcontracting the machines to Fimi Ltd is included. |
| Depreciation | Not a relevant cost | 0 | Depreciation is not a cash flow and, therefore, not a relevant cost. |
| Overheads | Absorbed overheads | 0 | Fixed overheads are irrelevant unless they change as a result of the decision. |
| Estimate Costs | Already incurred | 0 | Past costs (sunk costs) are irrelevant to the decision. |
| Total Relevant Cost | 47,400 | ||
| Revenue | 10 machines × GH¢5,200 | 52,000 | |
| Profit | 4,600 | Semenhyia Ltd should accept the contract as it generates a profit of GH¢4,600. |
(13 marks)
c) Distinction Between Marginal Cost and Differential Cost:
- Marginal Cost: This is the additional cost incurred when producing one more unit of output. It primarily refers to variable costs, as these costs increase with each additional unit produced.
- Differential Cost: This refers to the change in total cost that arises from choosing one alternative over another. It includes both variable and fixed costs and reflects the total difference between the costs of two alternatives.
The key distinction is that marginal cost focuses on the cost of producing one additional unit, while differential cost compares the total costs between two different decisions.
(4 marks)
- Topic: Decision making techniques, Relevant Cost and Revenue
- Series: DEC 2023
- Uploader: Kwame Aikins