job.
Materials Y and Z: The relevant cost of the additional quantities that will have to be purchased is their current replacement cost.
Material Y: units already held in inventory. The relevant cost of these units is their opportunity cost, which is the cash that could be obtained by disposing of them.
Material Z: units already held in inventory. The relevant cost of these units is the higher value of their disposal value (Rs.20 per unit) and the contribution that they
Relevant costs
Rs. Rs.
Material X: 800 units Rs.23 18,400
Material Y:
Opportunity cost of units in inventory = disposal value
(400 units Rs.12) 4,800
Purchase cost of additional units (200 units Rs.19) 3,800
8,600 Material Z:
Opportunity cost of units in inventory = (300 units Rs.25) 7,500 Purchase cost of additional units (200 units Rs.40) 8,000
15,500
Total relevant cost of materials 42,500
12.3 PRINTING LEAFLETS
(a) Tutorial note: The volume of sales required to achieve a target profit is an application of CVP analysis.
Rs. Rs.
Target profit 5,400
General fixed costs 12,000
Specific fixed costs:
Leaflet Type A 7,200
Leaflet Type B 12,000
Leaflet Type C 28,500
Total contribution required 65,100
Contribution from:
50,000 Leaflets Type A: (50 (300 – 120)) 9,000 50,000 Leaflets Type B: (50 (660 – 210)) 22,500
31,500 Contribution required from Leaflets Type C 33,600
The contribution from Leaflets Type C is Rs.(1,350 – 390) = Rs.960 per 1,000 leaflets.
The sales quantity of Leaflets Type C required to achieve a target profit of Rs.5,400 each month is therefore Rs.33,600/Rs.960 per 1,000 = 35,000 leaflets.
(b)
Relevant costs Rs.
Materials
To be purchased: 10,000 Rs.500/1,000 5,000
Currently held in inventory 6,000
(Relevant cost = higher of [Rs.1,500 and (20,000 Rs.300/1,000)]
Variable costs of labour/overheads 2,400
(30,000 Rs.80/1,000)
Total relevant costs (13,400)
Contract price 25,000
Incremental profit 11,600
12.4 JD
The contract should be accepted if the revenue from the contract will exceed the relevant costs of the contract.
Workings
Material M1. This material is in continuous/regular use. The relevant cost of the 1,000 kilograms is their replacement cost.
Relevant cost = 400 components × 3 kilos × Rs.5.50 per kilo = Rs.6,600.
Material P2. The material held in inventory has a relevant cost that is the higher of its scrap value (Rs.1.50) and the costs saved by putting it to an alternative use, which is Rs.2 (Rs.3.60 – Rs.1.60).
There are more units held in stock than are needed for the contract. The excess quantity should be ignored.
Relevant cost of material in stock = 400 components × 2 kilos × Rs.2 per kilo = Rs.1,600.
Part 678. Relevant cost = 400 components × Rs.50 = Rs.20,000.
Skilled labour. The relevant cost of skilled labour is the extra cash that would have to be spent to hire additional labour.
Relevant cost = 400 components × 5 hours per component × Rs.4 per hour = Rs.8,000.
Semi-skilled labour. Relevant cost = 400 components × 5 hours per component × Rs.3 per hour = Rs.6,000.
Variable overheads. It is assumed that the overhead absorption rate for variable overheads is the rate at which cash expenditure is incurred on variable overheads.
Relevant cost = 400 components × 4 machine hours per component × Rs.7 per machine hour = Rs.11,200.
Relevant cost statement Rs.
Material M1 6,600
Material P2 1,600
Part 678 20,000
Skilled labour 8,000
Semi-skilled labour 6,000
Variable overheads 11,200
Incremental fixed costs 3,200
Total relevant costs 56,600
Contract sales value (400 Rs.145) 58,000
Incremental profit 1,400
Undertaking the contract will add Rs.1,400 to total profit. On a purely financial basis, this means that the contract is worth undertaking. However, management might take the view that a higher profit margin is desirable, and the suggested price of Rs.145 per component might be negotiable.
12.5 PRODUCT B22
Workings for relevant costs Material X
The company has enough kilograms of material X in inventory for the contract.
When it is used, the inventory of material X will not be replaced. The relevant cost of the material is therefore its opportunity cost, not its replacement cost. The
opportunity cost is the higher of its current sale value (Rs.7.50 per kg) or the net saving obtained if it is used as a substitute for material Z (Rs.9.50 – Rs.1.50 = Rs.8 per kg). The relevant cost of material X is therefore Rs.8 per kg.
Material Y
Material Y is in regular use, so its relevant cost is its current replacement cost.
kg Rs.
Total inventory 10,000 142,750
Purchased six months ago 3,000 ( Rs.13.75) 41,250
Purchased last month 7,000 101,500
Purchase price last month = Rs.101,500/7,000 kg = Rs.14.50 per kg.
Current purchase price = 4% higher = Rs.14.50 × 1.04 = Rs.15.08.
Skilled labour
Skilled labour is in short supply. If it is used to make product B22, workers will have to be taken off other work. The relevant cost of skilled labour is the wages for the skilled workers for the time spent on B22, plus the lost contribution (net of skilled labour cost) from not being able to make units of product B16.
Opportunity cost of skilled labour
Skilled labour cost per unit of Product B16 = Rs.24 Number of hours per unit = 3 hours
Contribution per unit of B16 = Rs.45
Contribution per skilled labour hour from B16 = Rs.15
Opportunity cost of skilled labour if it is used to make B22 = (500 × 5) × Rs.15 = Rs.37,500
Unskilled labour
900 unskilled labour will be available at no incremental cost to the company (as it is already being paid and is not fully employed). There is no relevant cost for these hours. The additional 600 hours required will involve extra wage payments, including overtime payments. The relevant cost of these 600 hours is Rs.6 per hour × 150% = Rs.9 per hour, including the overtime premium.
Overheads
Variable overheads are included as relevant costs because they will be additional costs if the units of B22 are made. The only incremental fixed costs, however, are the extra cash costs of Rs.4,000. The fixed overhead absorption rate is ignored. The additional costs of hiring special finishing machinery are also included as a relevant cost.
Development costs
Those costs already incurred are past costs (sunk costs) and are not relevant. The future development costs involve additional expenditure and are included as relevant costs.
Minimum price for making 500 units of B22
Materials: Rs.
Fixed Incremental spending 4,000
Machine hire (2 weeks Rs.2,650) 5,300
Development costs 1,750
Minimum price 143,940
12.6 FAZAL INDUSTRIES LIMITED
Revised Statement of Estimated Costs Under the Opportunity Cost Approach
Rupees
Materials
X (1,500,000 x 80%) 1,200,000
Y (NRV) 1,470,000
Z (Purchase price) 2,250,000
Labour
Skilled 4,050,000
Unskilled 2,250,000
Supervisory (Rs. 15,000 x 2 x 12) 360,000*
Overheads
Avoidable fixed overhead 875,000
Variable overheads (Rs. 8,500,000 – Rs. 4,050,000) 4,450,000
16,905,000
Conclusion:
The company should accept the order as it will give them incremental cash flows of Rs. 2,095,000 (Rs.19,000,000-Rs.16,905,000).
12.7 DESCRIBE TERMS
(a) Opportunity cost:An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of one course of action requires that an alternative course of action be given up.
Example
A company has an opportunity to obtain a contract for the production of Z which will require processing on machine X which is already working at full capacity. The contract can only be fulfilled by reducing the present output of machine X which will result in reduction of profit contribution by Rs. 200,000.
If the company accepts the contract, it will sacrifice a profit contribution of Rs.
200,000 from the lost output of product Z. This loss of Rs. 200,000 represents an opportunity cost of accepting the contract.
(b) Sunk cost
A sunk cost is a historical or past cost that the company has already incurred.
These costs cannot be changed/recovered in any case and are ignored while making a decision.
Example
A company mistakenly purchased a machine that does not completely suit its requirements. The price of the machine already paid is a sunk cost and will not be considered while deciding whether to sell the machine or use it.
(c) Relevant cost:
The predicted future costs that would differ depending upon the alternative courses of action, are called relevant costs.
Example whereas the raw material cost of Rs. 100,000 is irrelevant.
12.8 TOPAZ LIMITED
Calculation of unit price to be quoted to Pearl Limited:
Material (25,000 × 200)+(53,125 × 225) + 80,000 W-1 17,033,125 Labour (20,000 ×45 × 40%) + (210,625 × 45) W-2 9,838,125
Variable overhead (230,625 × Rs. 25) 5,765,625
Incremental fixed cost (22m / 10 ×1.5) 3,300,000
35,936,875
Profit margin (25% of cost) 8,984,219
Sale price 44,921,094
Sale price per unit ( Rs. 44,921,094 / 150,000) 299
W-1: Material
Input units of material C (150,000 / 96%) × 0.5 78,125
W-2: Labour
Labour hours – completed units 150,000 x 1.50 225,000 – lost units {[(150,000 / 0.96) – 150,000] × 1.5 × 60%} 5,625 230,625
12.9 TYCHY LIMITED
Tychy Limited (TL)
Note Rs.
Technical manager – meeting 1 NIL
Wire – C 2 8,160
Total relevant cost 14,860
Notes:
1. In case of technical manager’s meeting with the potential client, the relevant cost is NIL because it is not only a past cost but also the manager is paid an annual salary and therefore TL has incurred no incremental cost on it.
2. Since wire-C is regularly used by TL, its relevant value is its replacement cost. The historical cost is not relevant because it is a past cost and the resale value is not relevant since TL is not going to sell it.
3. Since wire-D is to be purchased for the contract therefore its purchase cost is relevant. TL only requires 50 kg of wire-D but due to the requirement of minimum order quantity TL will be purchasing 60 kg of the material and since TL has no other use for this material, the full cost of purchasing the 60 kg is the relevant cost.
4. Since the components are to be purchased from the market at a cost of Rs.
80 each. Therefore, the entire purchase price is a relevant cost.
5. The 100 hours of direct labour are presently idle and hence have zero relevant cost. The remaining 150 hours are relevant. TL has two choices:
either use its existing employees and pay them overtime at Rs. 23 per hour which is a total cost of Rs. 3,450: or engage the temporary workers which would cost TL Rs. 3,250 including supervision cost of Rs. 100. The relevant cost is the cheaper of the two alternatives i.e. Rs. 3250.
6. The lease cost of machine will be incurred regardless of whether it is used for the manufacture of motors or remains idle. Hence, only the incremental running cost of Rs. 15 per hour is relevant.
7. Fixed overhead costs are incurred whether the work goes ahead or not so it is not a relevant cost.
CHAPTER 13 - COST-VOLUME-PROFIT (CVP) ANALYSIS
13.1 OCTA ELECTRONICS
(a) Break even point in Rupees Less: variable expense 13,500,000 Contribution margin 9,000,000
Contribution margin % 40% (9,000,000 / 22,500,000)
Margin of safety = Current sales - Break even sales Current sales
Less: variable expense 16,500,000 (Rs.13,500,000 + 5,000 x Rs. 600) Contribution margin 6,000,000
Contribution margin % 26.67% (Rs. 6,000,000 / Rs. 22,500,000) Break even point in units
Break even point in units = Fixed Expense Contribution margin per unit
= 6,300,000 New contribution per unit
Selling price Rs. 4,500
Less: variable expenses Rs. 1,650 (Rs. 16,500,000 / 5,000 x 50%) Contribution margin Rs. 2,850
New breakeven point in units to achive net income of Rs. 3,150,000t unit