Tutorial 3: SPECIAL ORDER DECISION (Relevant costs)

Question 1

GF Limited is a small specialist manufacturer of electronic components and much of its

output is used by the makers of aircraft for both civil and military purposes. One of the few
aircraft manufacturers has offered a contract to GF Limited for the supply, over the next 12
months, of 400 identical components.

The data relating to the production of each component are as follows:

(i) Material requirements:
3kg material M1 – see Note 1 below
2kg material P2 – see Note 2 below
1 Part No. 678 – see Note 3 below

Note 1. Material M1 is in continuous use by the company. 1,000kg are currently

held in stock at a book value of $4.70 per kg but it is known that future purchases
will cost $5.50 per kg.

Note 2. 1,200kg of material P2 are held in stock. The original cost of this material
was $4.30 per kg but as the material has not been required for the last two years
it has been written down to $1.50 per kg scrap value. The only foreseeable
alternative use is as a substitute for material P4 (in current use) but this would
involve further processing costs of $1.60 per kg. The current cost of material P4
is $3.60 per kg.

Note 3. It is estimated that Part No. 678 could be bought for $50 each.

(ii) Labour requirements: Each component would require five hours of skilled labour
and five hours of semi-skilled. An employee possessing the necessary skills is
available and is currently paid $12 per hour. A replacement would, however, have
to be obtained at a rate of $13 per hour for the work which would otherwise be
done by the skilled employee. The current rate for semi-skilled work is $10 per
hour and an additional employee could be appointed for this work.

(iii) Overhead: GF Limited absorbs overhead by a machine hour rate, currently $20
per hour of which $7 is for variable overhead and $13 for fixed overhead. If this
contract is undertaken it is estimated that fixed costs will increase for the duration
of the contract by $3,200. Spare machine capacity is available and each
component would require four machine hours.

A price of $250 per component has been suggested by the large company which makes
aircraft.

Required:
a) State whether or not the contract should be accepted and support your conclusion with
appropriate figures for presentation to management. [14 marks]
b) Comment briefly on THREE factors that management ought to consider and which may
influence their decision. [6 marks]
 (a) The relevant costs for the production of 400 components are as follows:

Materials:
($)
M1 (1,200kg at $5.50 replacement cost) – 2 6,600
marks
P2 (800kg at $2 per kg) – 3 marks 1,600
Part no. 678 (400 at $50 replacement cost) – 1 20,000
mark
Labour:
Skilled (2,000 hours at $13 per hour) – 1 mark 26,000
Semi-skilled (2,000 hours at $10 per hour) – 1 20,000
mark
Overheads:
Variable (1,600 machine hours at $7 per hour) – 1 mark 11,200
Fixed: Incremental fixed costs – 1 mark 3,200
Total relevant cost 88,600
Contract price (400 components at $250 per component) – 100,000
1 mark
Contribution to general fixed costs – 1 mark 11,400
The incremental revenues exceed the incremental costs. Therefore, the
contract should be accepted subject to the comments in (b) below. (2 marks)

If materials P2 are not used on the contract, they will be used as a substitute for
material P4. Using P2 as a substitute for P4 results in a saving of $2 ($3.60 − $1.60)
per kg. Therefore the relevant cost of P2 consists of the opportunity cost of $2 per
kg.

(b)Three factors which should be considered are: (6 marks in total – 2

marks for each factor)

1) Can a price higher than $250 per component be negotiated? The contract only
provides a contribution of $11,400 to general fixed costs. If the company
generates insufficient contribution from its activities to cover general fixed costs
then it will incur losses and will not be able to survive in the long term. It is
assumed that acceptance of the contract will not lead to the rejection of other
profitable work.
2) Will acceptance of the contract lead to repeat orders which are likely to generate
contribution to general fixed cost
3) Acceptance of the contract will provide additional employment for 12 months, and
this might have a significant effect on the morale of the workforce.

Question 2
The Hi Life Co (HL Co) makes sofas. It has recently received a request from a customer to provide a
one-off order of sofas, in excess of normal budgeted production. The order would need to be
completed within two weeks. The following cost estimate has already been prepared:

Direct materials: Note $

Fabric 200 m2 at $17 per m2 1 3,400
Wood 50 m2 at $8·20 per m2 2 410
Direct labour:
Skilled 200 hours at $16 per hour 3 3,200
Semi-skilled 300 hours at $12 per hour 4 3,600
Factory overheads 500 hours at $3 per hour 5 1,500
–––––––
Total production cost 12,110
Administration overheads at 10% of total production cost 6 1,211
–––––––
Total cost 13,321
–––––––
Notes
1 The fabric is regularly used by HL Co. There are currently 300 m2 in inventory, which cost
$17 per m2. The current purchase price of the fabric is $17·50 per m2.
2 This type of wood is regularly used by HL Co and usually costs $8·20 per m2. However,
the company’s current supplier’s earliest delivery time for the wood is in three weeks’
time. An alternative supplier could deliver immediately but they would charge $8·50 per
m2. HL Co already has 500 m2 in inventory but 480 m2 of this is needed to complete
other existing orders in the next two weeks. The remaining 20 m2 is not going to be
needed until four weeks’ time.
3 The skilled labour force is employed under permanent contracts of employment under
which they must be paid for 40 hours’ per week’s labour, even if their time is idle due to
absence of orders. Their rate of pay is $16 per hour, although any overtime is paid at time
and a half. In the next two weeks, there is spare capacity of 150 labour hours.
4 There is no spare capacity for semi-skilled workers. They are currently paid $12 per hour
or time and a half for overtime. However, a local agency can provide additional semi-
skilled workers for $14 per hour.
5 The $3 absorption rate is HL Co’s standard factory overhead absorption rate; $1·50 per
hour reflects the cost of the factory supervisor’s salary and the other $1·50 per hour
reflects general factory costs. The supervisor is paid an annual salary and is also paid
$15 per hour for any overtime he works. He will need to work 20 hours’ overtime if this
order is accepted.
6 This is an apportionment of the general administration overheads incurred by HL Co.

Required:
Prepare, on a relevant cost basis, the lowest cost estimate which could be used as the
basis for the quotation. Explain briefly your reasons for including or excluding each of the
costs in your estimate. (10 marks)

Direct materials: Note $

Fabric 200 m2 at $17·50 per m2 1 3,500
Wood 20 m at $8·20 per m 2 164
30 m at $8·50 per m 2 255
Direct labour:
Skilled 50 hours at $24 per hour 3 1,200
Semi-skilled 300 hours at $14 per hour 4 4,200
Factory overheads 20 hours at $15 per hour 5 300
Administration overheads 6 –
––––––
Total cost 9,619
––––––

1 Since the material is in regular use by HL Co, it is replacement cost which is the relevant cost for the
contract.
2 30 m will have to be ordered from the alternative supplier for immediate delivery but the remaining
20 m can be used from inventory and replaced by an order from the usual supplier at a cost of $8·20
per m.
3 There is no cost for the first 150 hours of labour because there is spare capacity. The remaining 50
hours will be paid at time and a half, which is $16 x 1·5, i.e. $24 per hour.
4 HL Co will choose to use the agency workers, who will cost $14 per hour, since this is cheaper than
paying existing semi-skilled workers at $18 per hour ($12 x 1·5) to work overtime.
5 None of the general factory costs are incremental, so they have all been excluded. However, the
supervisor’s overtime pay is incremental, so has been included. The supervisor’s normal salary, on
the other hand, has been excluded because it is not incremental.
6 These are general overheads and are not incremental, so no value should be included for them.