Opportunity costs

FM – L2 – Q54 – Discounted Cash Flow

Calculate NPV for Kumasi Motors Ltd's new product line, considering capital expenditure, market share, and opportunity costs over four years.

Question

Kumasi Motors Ltd, a manufacturer of car accessories, is considering a new product line. This project would commence at the start of Kumasi Motors Ltd’s next financial year and run for four years. Kumasi Motors Ltd’s next year-end is 31st December 2005.

The following information relates to the project:
A feasibility study costing GH¢8 million was completed earlier this year but will not be paid for until March 20X6. The study indicated that the project was technically viable.

Capital expenditure
If Kumasi Motors Ltd proceeds with the project, it would need to buy new plant and machinery costing GH¢180 million to be paid for at the start of the project. It is estimated that the new plant and machinery would be sold for GH¢25 million at the end of the project.
If Kumasi Motors Ltd undertakes the project, it will sell an existing machine for cash at the start of the project for GH¢2 million. This machine had been scheduled for disposal at the end of 20X7 for GH¢1 million.

Market research
Industry consultants have supplied the following information:
Market size for the product is GH¢1,100 million in 20X5. The market is expected to grow by 2% per annum.

Market share projections should Kumasi Motors Ltd proceed with the project are as follows:

	20X6	20X7	20X8	20X9
Market share	–	0.07	0.09	0.15

Subcontractors
Some of the work on the project would be performed by subcontractors who would be paid the following amounts:

Year	20X6	20X7	20X8	20X9
Payments to subcontractors (GH¢ million)	10	12	15	15

Fixed overheads
Incremental fixed overheads (all cash expenses) will be GH¢5 million in each of the four years of the project.

Labour costs
At the start of the project, employees currently working in another department would be transferred to work on the new product line. These employees currently earn GH¢3.6 million. An employee currently earning GH¢2 million would be promoted to work on the new line at a salary of GH¢3 million per annum. A new employee would be recruited to fill the vacated position.
As a direct result of introducing the new product line, employees in another department currently earning GH¢4 million would have to be made redundant at the end of 20X6 and paid redundancy pay of GH¢6 million at the end of 20X7.

Material costs
The company holds a stock of Material X which cost GH¢6.4 million last year. There is no other use for this material. If it is not used, the company would have to dispose of it at a cost to the company of GH¢2 million in 20X6. This would occur early in 20X6.
Material Z is also in stock and will be used on the new line. It cost the company GH¢3.5 million some years ago. The company has no other use for it, but could sell it on the open market for GH¢3 million early in 20X6.

Further information
The year-end payables are paid in the following year.
The company’s cost of capital is a constant 10% per annum.
It can be assumed that operating cash flows occur at the year-end.
Time 0 is 1st January 20X6 (t1 is 31st December 20X6, etc.)

Required
Calculate the net present value of the proposed new product line (work to the nearest million).

Answer

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Tags: Capital Expenditure, Cash Flows, Discounted cash flow, Inflation, Market share, NPV, Opportunity costs, Taxation
Level: Level 2

Topic: DCF: Specific Applications

MA – L2 – Q36 – Decision Making Techniques

Decide whether Akroma Ghana Limited should produce Item B internally or buy from a supplier under two conditions.

Question

Akroma Ghana Limited has a machine with which it produces Item A. Ten (10) machine hours are required to produce the item. This product’s selling price is GH₵150 with a variable cost of GH₵60. The company has just received an order for the supply of Item B. Each unit of Item B will require four (4) machine hours. The annual quantity of Item B required is 12,000 units and the cost estimates for the quantity is given below:

	GH₵
Direct material	125,000
Direct wages	52,000
Variable overheads	58,000
Floor space occupancy	11,500
Depreciation	7,500
Salary of Inspector for Item B alone	10,000
Total Cost	264,000

It was noted that Item B could be outsourced from a supplier at a cost of GH₵28 per unit.
You are required to assist management to decide whether to produce Item B internally or to buy from an outside supplier if the following conditions exist:
(i) Production of Item B will not in any way disturb the production of Item A.
(ii) The machine producing Item A is already fully engaged.

(B) List any FIVE steps in the management decision-making process.

Answer

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Tags: contribution margin, Incremental costs, Machine Hours, Make-or-Buy Decision, Opportunity costs, Relevant costs
Level: Level 2

Topic: Decision making techniques, Relevant cost and revenue

MA – L2 – Q35 – Relevant cost and revenue

Compute relevant cost of producing a motor, considering materials, labour, machine costs, and overheads, with reasons for cost inclusion/exclusion.

Question

Apex Manufacturing Limited (AML) is engaged in the manufacture of specialised motors. The company has been asked to provide a quotation for building a motor for a large textile industrial unit in Kumasi. Following information has been obtained by AML’s technical manager in a one-hour meeting with the potential customer. The manager is paid an annual salary equivalent to GH¢2,500 per eight-hour day.

(i) The motor would require 120 ft. of Wire-C which is regularly used by AML in production. AML has 300 ft. of Wire-C in inventory at the cost of GH¢65 per ft. The resale value of Wire-C is GH¢63 and its current replacement cost is GH¢68 per ft.

(ii) 50 kg of another material viz. Wire-D and 30 other small components would also be required by AML for the motor. Wire-D would be purchased from a supplier at GH¢10 per kg. The supplier sells a minimum quantity of 60 kg per order. However, the remaining quantity of Wire-D will be of no use to AML after the completion of the contract. The other small components will be purchased from the market at GH¢80 per component.

(iii) The manufacturing process would require 250 hours of skilled labour and 30 machine hours.
The skilled workers are paid a guaranteed wage of GH¢20 per hour and the current spare capacity available with AML for such class of workers is 100 direct labour hours. However, additional labour hours may be obtained by either:

Paying overtime at GH¢23 per hour; or
Hiring temporary workers at GH¢21 per hour. These workers would require 5 hours of supervision by AML’s existing supervisor who would be paid overtime of GH¢20 per hour.
The machine on which the motor would be manufactured was leased by AML last year at a monthly rent of GH¢5,000 and it has a spare capacity of 110 hours per month. The variable running cost of the machine is GH¢15 per hour.

(iv) Fixed overheads are absorbed at the rate of GH¢25 per direct labour hour.

Required:
Compute the relevant cost of producing the textile motor. Give brief reasons for the inclusion or exclusion of any cost from your computation.

Answer

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Tags: Cost analysis, decision making, fixed costs, Incremental costs, Labour costs, Material costs, Opportunity costs, Relevant costs, Special order, variable costs
Level: Level 2

Topic: Decision making techniques, Relevant cost and revenue

MA – L2 – Q34 – Relevant cost and revenue

Calculate minimum price for 500 units of Product M22, considering relevant costs of materials, labour, overheads, and development.

Question

KK Enterprises has received an enquiry from a customer for the supply of 500 units of a new product, Product M22. Negotiations on the final price to charge the customer are in progress and the sales manager has asked you to supply relevant cost information.
The following information is available:

(1) Each unit of Product M22 requires the following raw materials:

Raw material type	Quantity
X	4 kg
Y	6 kg

(2) The company has 5,000 kg of material X currently in stock. This was purchased last year at a cost of GH¢7 per kg. If not used to make Product M22, this inventory of X could either be sold for GH¢7.50 per kg or converted at a cost of GH¢1.50 per kg, so that it could be used as a substitute for another raw material, material Z, which the company requires for other production. The current purchase price per kilogram for materials is GH¢9.50 for material Z and GH¢8.25 per kg for material X.

(3) There are 10,000 kilograms of raw material Y in inventory, valued on a FIFO basis at a total cost of GH¢142,750. Of this current inventory, 3,000 kilograms were purchased six months ago at a cost of GH¢13.75 per kg. The rest of the inventory was purchased last month. Material Y is used regularly in normal production work. Since the last purchase of material Y a month ago, the company has been advised by the supplier that the price per kilogram has been increased by 4%.

(4) Each unit of Product M22 requires the following number of labour hours in its manufacture:

Type of labour	Hours
Skilled	5
Unskilled	3

Skilled labour is paid GH¢8 per hour and unskilled labour GH¢6 per hour.

(5) There is a shortage of skilled labour, so that if production of M22 goes ahead it will be necessary to transfer skilled workers from other work to undertake it. The other work on which skilled workers are engaged at present is the manufacture of Product M16. The selling price and variable cost information for M16 are as follows:

	GH¢ per unit
Selling price	100
Less: variable costs of production
Skilled labour (3 hours)	24
Other variable costs	31
	55
Contribution	45

(6) The company has a surplus of unskilled workers who are paid a fixed wage for a 37-hour week. It is estimated that there are 900 hours of unused unskilled labour time available during the period of the contract. The balance of the unskilled labour requirements could be met by working overtime, which is paid at time and a half.

(7) The company absorbs production overheads by a machine hour rate. This absorption rate is GH¢22.50 per hour, of which GH¢8.75 is for variable overheads and the balance is for fixed overheads. If production of Product M22 is undertaken, it is estimated that an extra GH¢4,000 will be spent on fixed costs. Spare machining capacity is available and each unit of M22 will require two hours of machining time in its manufacture using the existing equipment. In addition, special finishing machines will be required for two weeks to complete the M22. These machines will be hired at a cost of GH¢2,650 per week, and there will be no overhead costs associated with their use.

(8) Cash spending of GH¢3,250 has been incurred already on development work for the production of M22. It is estimated that before production of the M22 begins, another GH¢1,750 will have to be spent on development, making a total development cost of GH¢5,000.

Required:
Calculate the minimum price that the company should be prepared to accept for the 500 units of Product M22. Explain briefly but clearly how each figure in the minimum price calculation has been obtained.
(Note: The minimum price is the price that equals the total relevant costs of producing the items. Any price in excess of the minimum price will add to total profit).

Answer

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Tags: Cost analysis, decision making, fixed costs, Incremental costs, Labour costs, Material costs, Minimum price, Opportunity costs, Relevant costs, variable costs
Level: Level 2

Topic: Decision making techniques, Relevant cost and revenue

Tag (SQ): Opportunity costs

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FM – L2 – Q54 – Discounted Cash Flow

Calculate NPV for Kumasi Motors Ltd's new product line, considering capital expenditure, market share, and opportunity costs over four years.

MA – L2 – Q36 – Decision Making Techniques

Decide whether Akroma Ghana Limited should produce Item B internally or buy from a supplier under two conditions.

MA – L2 – Q35 – Relevant cost and revenue

Compute relevant cost of producing a motor, considering materials, labour, machine costs, and overheads, with reasons for cost inclusion/exclusion.

MA – L2 – Q34 – Relevant cost and revenue

Calculate minimum price for 500 units of Product M22, considering relevant costs of materials, labour, overheads, and development.

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FM – L2 – Q54 – Discounted Cash Flow

Calculate NPV for Kumasi Motors Ltd's new product line, considering capital expenditure, market share, and opportunity costs over four years.

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MA – L2 – Q36 – Decision Making Techniques

Decide whether Akroma Ghana Limited should produce Item B internally or buy from a supplier under two conditions.

You're reporting an error for "MA – L2 – Q36 – Decision Making Techniques"

MA – L2 – Q35 – Relevant cost and revenue

Compute relevant cost of producing a motor, considering materials, labour, machine costs, and overheads, with reasons for cost inclusion/exclusion.

You're reporting an error for "MA – L2 – Q35 – Relevant cost and revenue"

MA – L2 – Q34 – Relevant cost and revenue

Calculate minimum price for 500 units of Product M22, considering relevant costs of materials, labour, overheads, and development.

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