- 20 Marks
MA – L2 – Q52a – Relevant Cost and Revenue
Question
Okonku Enterprises produces Single, Double, and King size beds for sale to hotels in West Africa. Its manufacturing plant is located in Keta and is currently producing at 100% capacity. Below is the annual output and sales for each product and the associated costs.
| Product | Single bed | Double bed | King Size |
|---|---|---|---|
| Units sold | 5,000 units | 3,500 units | 4,000 units |
| Sales | GH₵ 2,500,000 | GH₵ 2,800,000 | GH₵ 3,800,000 |
| Cost | |||
| Material cost | 750,000 | 1,400,000 | 1,520,000 |
| Labour costs | 600,000 | 1,050,000 | 1,200,000 |
| Manufacturing O’head | 200,000 | 650,000 | 300,000 |
| Administrative cost | 200,000 | 100,000 | 200,000 |
| Total cost | 1,750,000 | 3,200,000 | 3,220,000 |
| Profit /Loss | 750,000 | (400,000) | 580,000 |
The Director of Okonku is of the view that the product Double bed is not doing well and must not be produced any longer. The following additional information has been provided.
(i) 40% of the labour cost for all bed types are fixed costs.
(ii) 50% of the manufacturing overhead is variable costs for all products.
(iii) 80% of the administrative cost is fixed.
Required:
(a) Advise whether the company should shut down the production of Double beds.
(b) Should the company accept the new order assuming Double beds will still be produced?
Answer
(a) Calculation of contribution that will be lost if Double bed ceases production
| Item | GH₵ |
|---|---|
| Potential loss of Revenue | 2,800,000 |
| Less: | |
| Potential savings of material cost | 1,400,000 |
| Potential savings in variable labour cost (60% × 1,050,000) | 630,000 |
| Potential savings in variable manufacturing overhead (50% × 650,000) | 325,000 |
| Potential savings in variable administrative costs (20% × 100,000) | 20,000 |
| Total potential savings in variable cost | 2,375,000 |
| Potential contribution to fixed cost that will be lost | 425,000 |
From this calculation, it implies that a contribution of GH₵ 425,000 will be lost if Double bed production ceases. Profit will decline by this figure since fixed cost components will still be incurred. Therefore, the company should continue production.
Alternatively
| Item | Single beds (GH₵) | Double beds (GH₵) | King Size Beds (GH₵) | Total (GH₵) |
|---|---|---|---|---|
| Sales | 2,500,000 | 2,800,000 | 3,800,000 | 9,100,000 |
| Material cost | 750,000 | 1,400,000 | 1,520,000 | 3,670,000 |
| Labour cost | 600,000 | 1,050,000 | 1,200,000 | 2,850,000 |
| M O’head | 200,000 | 650,000 | 300,000 | 1,150,000 |
| Admin | 200,000 | 100,000 | 200,000 | 500,000 |
| Total cost | 1,750,000 | 3,200,000 | 3,220,000 | 8,170,000 |
| Profit | 750,000 | (400,000) | 580,000 | 930,000 |
Statement of profit or loss (if Double beds are discontinued)
| Item | SB remaining (GH₵) | Fixed cost remaining (GH₵) | KSB (GH₵) | Total (GH₵) |
|---|---|---|---|---|
| Sales | 2,500,000 | 3,800,000 | 6,300,000 | |
| Material cost | 750,000 | 1,520,000 | 2,270,000 | |
| Labour cost | 600,000 | 420,000 | 1,200,000 | 2,220,000 |
| M O’head | 200,000 | 325,000 | 300,000 | 825,000 |
| Admin | 200,000 | 80,000 | 200,000 | 480,000 |
| Total cost | 1,750,000 | 825,000 | 3,220,000 | 5,795,000 |
| Profit | 750,000 | (825,000) | 580,000 | 505,000 |
In this case, profit reduced from GH₵ 930,000 to GH₵ 505,000, a reduction of GH₵ 425,000.
(b) Statement of profit or loss for 80 units of each product
| Item | Single beds (GH₵) | Double beds (GH₵) | King Size Beds (GH₵) | Total (GH₵) |
|---|---|---|---|---|
| Sales | 40,000 | 64,000 | 76,000 | 180,000 |
| Material cost | 12,000 | 32,000 | 30,400 | 74,400 |
| Labour cost (variable 60%) | 7,200 | 14,400 | 14,400 | 36,000 |
| M O’head (variable 50%) | 3,200 | 7,428.57 | 3,000 | 13,628.57 |
| Admin (variable 20%) | 640 | 228.57 | 400 | 1,268.57 |
| Total cost | 23,040 | 54,057.14 | 48,200 | 125,297.14 |
| Additional capacity cost | 80,000 | |||
| Profit | (25,297.14) |
Workings:
Sales
- Single beds: (2,500,000 ÷ 5,000) × 80 = 40,000
- Double beds: (2,800,000 ÷ 3,500) × 80 = 64,000
- King Size: (3,800,000 ÷ 4,000) × 80 = 76,000
Material cost
- Single beds: (750,000 ÷ 5,000) × 80 = 12,000
- Double beds: (1,400,000 ÷ 3,500) × 80 = 32,000
- King Size: (1,520,000 ÷ 4,000) × 80 = 30,400
Variable labour cost
- Single beds: (600,000 × 60% ÷ 5,000) × 80 = 7,200
- Double beds: (1,050,000 × 60% ÷ 3,500) × 80 = 14,400
- King Size: (1,200,000 × 60% ÷ 4,000) × 80 = 14,400
Variable manufacturing overhead
- Single beds: (200,000 × 50% ÷ 5,000) × 80 = 3,200
- Double beds: (650,000 × 50% ÷ 3,500) × 80 = 7,428.57
- King Size: (300,000 × 50% ÷ 4,000) × 80 = 3,000
Variable administrative cost
- Single beds: (200,000 × 20% ÷ 5,000) × 80 = 640
- Double beds: (100,000 × 20% ÷ 3,500) × 80 = 228.57
- King Size: (200,000 × 20% ÷ 4,000) × 80 = 400
The incremental profit from accepting the order is negative (GH₵ 25,297.14 loss). Therefore, the company should not accept the new order from Elom Lodge Limited, as it would result in a financial loss.
- Topic: Relevant cost and revenue
- Uploader: Salamat Hamid