Short Term Decision Making - Relevant Cost and Opportunity Cost

Q.1 Akbar Engineering Company

Akbar Engineering Company is considering to undertake a one year contract to produce

and supply part W to Nadir Manufacturing Company.
1 The contract will utilize an existing machine suitable for this work only. The machine

cost Rs. 250,000 five years ago and has a book value of Rs. 50,000. the machine could
be sold now for Rs. 80,000 or in one year's time for Rs. 10,000.
2 Four types of material would be needed for the contract as follows:

Units in
Required
Material
stock
for contract
W
1,200
300
X
200
1,100
Y
3,000
600
Z
1,800
2,400
W and Z are regular in use within the company.

Cost
price
18
8
5
18

Current
price
15
28
8
20

3 A research study for specification and designing was carried out 2 month ago

costing Rs. 25,000.

The
labour requirement and rates will be as follows:
4
skilled
400 hrs
@ Rs. 35 per hour
Semi skilled
300 hrs
@ Rs. 30 per hour
Unskilled
200 hrs
@ Rs. 20 per hour
At present skilled labour are in shortage so the company will make it necessary for the
skilled labours to be diverted from the other work on which a contribution margin of
Rs. 45 per hour is earned, net of wages cost. The firm currently has a surplus of
semi skilled workers paid at full rate but doing unskilled work. The labour concerned
could be transferred to provide sufficient labour for this contract and would be replaced
by unskilled workers.
5 Overhead cost are allocated to this contract @ Rs. 18 per skilled labour hours as

follows:

Fixed @ Rs. 13.00

Variable @ Rs. 5.00

6 This contract would require the services of an existing manager who would be paid

Rs. 12,000 per month. If not required for this contract he would be made redundant
and would receive Rs. 3,000 per month under service agreement.
7 The undertaking of this contract is expected to cause production of an existing product

Bango, to fall by 3,000 units. The profitability of Bango is as follows:

Sales price
Variable cost
80.00
Fixed Cost
15.00

120.00
95.00
25.00

Required:
Calculate the minimum price of the contract where there will be no loss no profit.
(Answer - Rs. 427,500)

Resale
value
12
21
6
19

Q.2 Another Customer

A company has been making a machine for a customer but the customer has, however,
gone into liquidation and there are no prospects that any money will be obtained from
the winding up of his company and the incomplete machine can be sold at Rs. 2,000 only.
Cost incurred to-date in manufacturing the machine are Rs. 50,000 and progress payments
of Rs. 15,000 have been received from the customer prior to liquidation.
The sales department has found another customer willing to buy the machine for Rs. 34,000
once it is completed.
To complete the machine following costs have to be incurred:
a) Material: These have been bought at a cost of Rs. 6,000. They have no other use, and
if the machine is not finished, They would be sold as scrape for Rs. 2,000.
b) Further labour costs would be Rs. 6,200. Labour is in short supply and if the machine
is not finished, the workforce would be switched over to another job, which earns
Rs. 30,000 in revenue, and incurs direct cost ( not including direct labour) Rs. 12,000,
and absorbs fixed overhead of Rs. 8,000.
c) Consultancy fees, Rs. 4,000. If the work is not completed, the consultant's contract
would be cancelled at a cost of Rs. 1,500.
d) General overheads of Rs. 10,500 would be added to the cost of the remaining work.
Required:

Should the new customer's offer be accepted?

(Answer - Net benefit for accepting new order Rs. 9,500)

Q.3 Publishing Company

You are the management accountant of a publishing and printing company which has
been asked for the production of a programme for the winter cricket season. The work
would be carried out in addition to the normal work of the company. Because of the
existing commitments, some weekend working would be required to complete the
printing of the programme. A trainee accountant has produced the following cost
estimate based upon the resources required as specified by the production manager.
Direct material - paper (book value)
ink (purchase price)
Direct labour - skilled
250 hours @ 40
unskilled
250 hours @ 35
variable overhead
350 hours @ 40
Printing press depreciation
200 hours @ 25
Fixed production costs
350 hours @ 60
Estimating department costs

Your are aware that considerable publicity could be obtained for the company if you
are able to win this order and the price quoted must be very competitive.
The following notes are relevant to the cost estimate above:
1 The paper to be used is currently in stock at a value of Rs. 50,000. It is
of an unusual colour which has not been used for some time. The
replacement price of the paper is Rs. 80,000. Whilst the scrap value of
that in stock is Rs. 25,000. The production manager does not foresee
any alternative use for the paper if it is not used for the programme.
2 The inks required are not held in stock. They would have to be purchased

Rs.
50,000
24,000
10,000
3,500
14,000
5,000
21,000
4,000
131,500

5
6

7
8

in bulk at a cost of Rs. 30,000. 80% of the ink purchased would be used
in printing the programme. No other use is foreseen for the remainder.
Skilled direct labour is in short supple, and to accommodate the printing of
the programmes, 50% of the time required would be worked at weekends
for which a premium of 25% above the normal hourly rate is paid. The
normal hourly rate is Rs. 40 per hour.
Unskilled labour is presently under-utilised, and at present 200 hours per
week are recorded as idle time. If the printing work is carried out at a
weekend, 25 unskilled hours would have to occur at this time, but the
employees concerned would be given two hours time off (for which they
would be paid) in lieu of each hour worked.
Variable overhead represents the cost of operating the printing press and
binding machine.
When not being used by the company, the printing press is hired to
outside company for Rs. 60 per hour. This earns a contribution of Rs. 30
per hour. There is unlimited demand for this facility.
Fixed production costs incurred by and absorbed into production, using
as hour rate based on budgeted activity.
The cost of estimating department represents time spent in discussion
with the cricket authority concerning the printing of its programme.

Required:
a Prepare a revised cost estimate using the opportunity cost approach,
showing clearly the minimum price that the company should accept
for the order. Give reasons for each resource valuation in your cost
estimate.
b Explain why contribution theory is used as a basis for providing
information relevant to decision making.
c Explain the relevance of opportunity costs in decision making.
(Answer - Rs. 88,875)
Q.4 Three Alternatives (ICMAP May 2007)

Brow Ltd. Is a company that has in stock some materials of type XY that cost Rs. 75,000
but these materials are now obsolete and has a scrap value of only Rs. 21,000. Other than
selling the material for scrap, there are only two alternative uses for them.
Alternative 1: Convert the obsolete materials into a specialised product, which would
require the following additional work and materials:
Material A
Material B
Direct labour
5,000 hors unskilled
5,000 hors semiskilled
5,000 hors highly skilled

600
1,000

units
units

Total 15,000 hours

Extra selling and delivery expenses

Extra advertising expenses

27,000
18,000

The conversion would produce 900 units of saleable products, and these could be sold

for Rs. 300 per unit

Material A is already in stock and is widely used within the firm. Although present stocks
together with orders already planned will be sufficient to facilitate normal activity, any
extra material used by adopting this alternative will necessitate such materials being
replaced immediately. Material B is also in stock, but it is unlikely that any additional
supplies can be obtained for some considerable time because of an industrial dispute.
At the present time material B is normally used in the production of Product Z, which
sells at Rs. 390 per unit and incur total variable cost (excluding material B) of Rs. 210
per unit. Each unit of product Z uses four units of Material B.
Material A
Material B
Rs.
Rs.
Acquisition cost at time of purchase
100 per unit
10 per unit
Net realizable value
85 per unit
18 per unit
Replacement cost
90 per unit
Alternative 2: Adopting the obsolete materials for use as a substitute for a sub-assembly
that is regularly used in the firm.
Details of the extra work and materials required are as follows:
Material C
1,000 units
Direct labour
4,000 hors unskilled
1,000 hors semiskilled
4,000 hors highly skilled Total 9,000 hours
1,200 units of the sub-assembly are regularly used per quarter at a cost of Rs. 900 per
unit. The adoption of material XY would reduce the quantity of the sub-assembly
purchased from outside the firm to 900 units for the next quarter only. However, since
the volume of purchases would be reduced, some discount would be lost, and the
price of those purchased from outside would increase to Rs. 1,050 per unit for the
quarter.
Material C is not available externally, but is manufactured by Brown Ltd. The 1,000 units
required would be available from stocks, but would be produced as extra production.
The standard cost per unit of material C would be as follows:
Rs.
Direct labour, 6 hours unskilled labour
Raw materials
Variable overhead, 6 hours at Re. 1
Fixed overhead, 6 hours at Rs. 3

The wages rates and overhead recovery rates for Brown Ltd are:
Variable overhead
Rs. 1 per direct labour hour
Fixed overhead
Rs. 3 per direct labour hour
Unskilled labour
Rs. 3 per direct labour hour
Semiskilled labour
Rs. 4 per direct labour hour
Highly skilled labour
Rs. 5 per direct labour hour
The unskilled labour is employed on a casual basis, and sufficient labour can be

18
13
6
18
55

acquired to exactly meet the production requirements. Semiskilled labour is part of

the permanent labour force, but the company has temporary excess supply of this
type of labour at the present time. Highly skilled labour is in short supply and cannot
be increased significantly in the short term; this labour is presently engaged in meeting
the demand for product L, which requires 4 hours of highly skilled labour. The CM
from sale of one unit of product L is Rs. 24.
Required:
Prepare and present cost information, advising whether the stocks of material XY
should be sold, converted into specialized product (alternative 1) or adapted for use a
substitute for a sub-assembly (alternative 2)
(Answer - Alternative 1 saving Rs. 20,000)
Q5

Fazal Industries Limited is currently negotiating a contract to supply its products to K-Mart,
a large chain of departmental stores. K-Mart finally offered to sign a one year contract at a
lump sum price of Rs. 19,000,000.
The Cost Accountant of Fazal Industries Limited believes that the offered price is too low.
However, the management has asked you to re-assess the situation. The cost accountant has
provided you the following information:
Statement of Estimated Costs (Project: K-Mart)
Notes
Rupees
Material:
X (at historical cost)
(i)
1,500,000
Y (at historical cost)
(ii)
1,350,000
Z
(iii)
2,250,000
Labour:
Skilled
(iv)
4,050,000
Unskilled
(v)
2,250,000
Supervisory
(vi)
810,000
Overheads
(vii)
8,500,000
Total cost
20,710,000
You have analysed the situation and gathered the following information:
(i) Material X is available in stock. It has not been used for a long time because a
substitute is currently available at 20% less than the cost of X.
(ii) Material Y was ordered for another contract but is no longer required. Its net realizable
value is Rs. 1,470,000.
(iii) Material Z is not in stock.
(iv) Skilled labour can work on other contracts which are presently operated by semiskilled
labour who have been hired on temporary basis at a cost of Rs. 325,000 per
month. The company will need to give them a notice of 30 days before terminating
their services.
(v) Unskilled labour will have to be hired for this contract.
(vi) Two new supervisors will be hired for this contract at Rs. 15,000 per month. The
present supervisors will remain employed whether the contract is accepted or not.
(vii) These include fixed overheads absorbed at the rate of 100% of skilled labour. Fixed
production overheads of Rs. 875,000 which would only be incurred if the contract is
accepted, have been included for determining the above fixed overhead absorption
rate.
Required:
Prepare a revised statement of estimated costs using the opportunity cost approach, for the

management of Fazal Industries and state whether the contract should be accepted or not.
(Answer - Yes saving Rs. 2.57 million)
Q6

Sun Fashions (Pvt.) Limited, a chain of retail garments store, has planned to introduce a
new fancy dress for babies at all its seven outlets in the country.
The company is also considering to introduce a matching crown scarf and handbag with
the new dress. Currently they are expecting to sell 15,000 dresses in the first six months
but the management feels that this sale can be increased by 30% if matching crown scarf
and handbag are marketed together.
The data relating to sales and production of dress, crown scarf and handbag are as
follows:
(i) Each dress requires three and half meter of cloth which is easily available in the
market at a price of Rs. 100 per meter. Part of the material left unused can be used to
manufacture a crown scarf and handbag.
(ii) The cost of cutting the dress, crown scarf and handbag is Rs. 35, Rs. 15 and Rs. 20
respectively.
(iii) The leftover pieces can be sold as under:
if only the dress is manufactured, Rs. 20 per dress;
if crown scarf and handbag is also manufactured, Rs. 5 per set.
(iv) The company has a contract with a designer firm at a monthly fee of Rs. 1,500,000.
However, in the case of handbag and crown scarf, the company will have to pay a
one time additional amount of Rs. 150,000 to the designer firm.
(v) Each handbag will require a metal hook which is available in the market at Rs. 10
per hook. However, the company has sufficient number of metal hooks in stock
which was purchased at Rs. 6 per hook. If the company does not opt for the
manufacturing of handbags, these hooks can be sold at Rs. 8 per hook.
(vi) The dresses, crown scarves and handbags are expected to be sold according to the
following mix:
Complete set 60%
Dress and crown scarf only 10%
Dress and handbag only 20%
Dress only 10%
(vii) The selling price and variable costs (besides those mentioned above) of each product
are as follows:
Selling Price per
Variable Costs
unit (Rs.)
(besides those mentioned above)
Dress
Crown scarf
Handbag

2,000
400
500

40% of selling price

55% of selling price
60% of selling price

Required:
Calculate the incremental profit or loss as a result of manufacturing handbags and crown
scarves with the dress.
(Answer - Rs. 8,279,700)

Q7

Topaz Limited (TL) is the manufacturer of consumer durables. Pearl Limited, one of the major
customers, has invited TL to bid for a special order of 150,000 units of product Beta.
Following information is available for the preparation of the bid.
(i) Each unit of Beta requires 0.5 kilograms (kg) of material C. This material is produced
internally in batches of 25,000 kg each, at a variable cost of Rs. 200 per kg. The setup cost per

batch is Rs. 80,000. Material C could be sold in the market at a price of Rs. 225 per kg. TL
has the capacity to produce 100,000 kg of material C; however, the current demand for
material C in the market is 75,000 kg.
(ii) Every 100 units of product Beta requires 150 labour hours. Workers are paid at the rate of
Rs. 9,000 per month. Idle labour hours are paid at 60% of normal rate and TL currently has
20,000 idle labour hours. The standard working hours per month are fixed at 200 hours.
(iii) The variable overhead application rate is Rs. 25 per labour hour. Fixed overheads are
estimated at Rs. 22 million. It is estimated that the special order would occupy 30% of the
total capacity. The production capacity of Beta can be increased up to 50% by incurring
additional fixed overheads. The fixed overhead rate applicable to enhanced capacity would be
1.5 times the current rate. The utilized capacity at current level of production is 80%.
(iv) The normal loss is estimated to be 4% of the input quantity and is determined at the time of
inspection which is carried out when the unit is 60% complete. Material is added to the
process at the beginning while labour and overheads are evenly distributed over the process.
(v) TL has the policy to earn profit at the rate of 20% of the selling price.
Required:
Calculate the unit price that TL could bid for the special order to Pearl Limited.
( Ans:299)

Q8

Tychy Limited (TL) is engaged in the manufacture of Specialized motors. The company has been
asked to provide a quotation for building a motor for a large textile industrial unit in Punjab.
Following information has been obtained by TLs technical manager in a one-hour meeting with
the potential customer. The manager is paid an annual salary equivalent to Rs. 2,500 per
eight-hour day.
(i) The motor would require 120 ft of wire-C which is regularly used by TL in production. TL
has 300 ft of wire-C in inventory at the cost of Rs. 65 per ft. The resale value of wire-C is Rs.
63 and its current replacement cost is Rs. 68 per ft.
(ii) 50 kg of another material viz. Wire-D and 30 other small components would also be
required by TL for the motor. Wire-D would be purchased from a supplier at Rs. 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 TL after the completion of the contract. The other small
components will be purchased from the market at Rs. 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 Rs. 20 per hour and the current spare
capacity available with TL for such class of workers is 100 direct labour hours. However,
additional labour hours may be obtained by either:
Paying overtime at Rs. 23 per hour; or
Hiring temporary workers at Rs. 21 per hour. These workers would require 5 hours
of supervision by ALs existing supervisor who would be paid overtime of Rs. 20 per
hour.
The machine on which the motor would be manufactured was leased by TL last year at a
monthly rent of Rs. 5,000 and it has a spare capacity of 110 hours per month. The variable
running cost of the machine is Rs. 15 per hour.
(iv) Fixed overheads are absorbed at the rate of Rs. 25 per direct labour hour.
Required:
Compute the relevant cost of producing textile motor. Give brief reasons for the inclusion or
exclusion of any cost from your computation. (10 marks)

Q9

The managing director of Parser Ltd, a small business, is considering undertaking

a one-off contract and has asked his inexperienced accountant to advise on what
costs are likely to be incurred so that he can price at a profit. The following schedule
has been prepared.
Costs for special order:
Note
Direct wages
Supervisor costs
General overheads
Machine depreciation
Machine overheads
Materials

Rs.
1
2
3
4
5
6

28,500
11,500
4,000
2,300
18,000
34,000
98,300

Notes:
1. Direct wages comprise the wages of two employees, particularly skilled in the
labour process for this job, who could be transferred from another department to
undertake work on the special order. They are fully occupied in their usual department
and sub-contracting staff would have to be bought-in to undertake the work left behind.
Subcontracting costs would be Rs. 32,000 for the period of the work. Different
subcontractors who are skilled in the special order techniques are available to work
on the special order and their costs would amount to Rs. 31,300.
2. A supervisor would have to work on the special order. The cost of Rs. 11,500 is
comprised of Rs. 8,000 normal payments plus 3,500 additional bonus for working on
the special order. Normal payments refer to the fixed salary of the supervisor. In
addition, the supervisor would lose incentive payments in his normal work amounting
to Rs. 2,500. It is not anticipated that any replacement costs relating to the
supervisor's work on other jobs would arise.
3. General overheads comprise an apportionment of Rs. 3,000 plus an estimate of
Rs. 1,000 incremental overheads.
4. Machine depreciation represents the normal period cost based on the duration of the
contract. It is anticipated that Rs. 500 will be incurred in additional machine
maintenance costs.
5. Machine overheads (for running costs such as electricity) are charged at Rs. 3 per
hour. It is estimated that 6000 hours will be needed for the special order. The machine
has 4000 hours available capacity. The further 2000 hours required will mean an
existing job is taken off the machine resulting in a lost contribution of 2 per hour.
6. Materials represent the purchase costs of 7,500 kg bought some time ago. The
materials are no longer used and are unlikely to be wanted in the future except on
the special order. The complete stock of materials (amounting to 10,000 kg), or part
thereof, could be sold for Rs. 420 per kg. The replacement cost of material used
would be Rs.33,375.
Because the business does not have adequate funds to finance the special order, a

bank overdraft amounting to Rs.20,000 would be required for the project duration of
three months. The overdraft would be repaid at the end of the period. The company
uses a cost of capital of 20% to appraise projects. The bank overdraft rate is 18%.
The managing director has heard that, for special orders such as this, relevant costing
should be used that also incorporates opportunity costs. He has approached you to
create a revised costing schedule based on relevant costing principles.
Required:
Adjust the schedule prepared by the accountant to a relevant cost basis, incorporating
appropriate opportunity costs.
(Ans 88,200)

Q 10

M is the holding company of a number of companies within the engineering sector. One of
these subsidiaries is PQR which specialises in building machines for manufacturing
companies. PQR uses absorption costing as the basis of its routine accounting system for
profit reporting.
PQR is currently operating at 90% of its available capacity, and has been invited by an
external manufacturing company, to tender for the manufacture of a bespoke machine. If
PQRs tender is accepted by the manufacturing company then it is likely that another
company within the M group will be able to obtain work in the future servicing the machine. As
a result, the Board of Directors of M are keen to win the tender for the machine and are
prepared to accept a price from the manufacturing company that is based on the relevant
costs of building the machine.
An engineer from PQR has already met with the manufacturing company to determine the
specification of the machine and he has worked with a non-qualified accountant from PQR to
determine the following cost estimate for the machine.
Note
$
Engineering specification
1
1,500
Direct material A
2
61,000
Direct Material B
3
2,500
Components
4
6,000
Direct Labour
5
12,500
Supervision
6
350
Machine hire
7
2,500
Overhead costs
8
5,500
Total
91,850
NOTES
1. The engineer that would be in charge of the project to build the machine has already
met with the manufacturing company, and subsequently prepared the specification for
the machine. This has taken three days of his time and his salary and related costs are
$500 per day. The meeting with the manufacturing company only took place because
of this potential work; no other matters were discussed at the meeting.
2. The machine would require 10,000 square metres of Material A. This material is
regularly used by PQR. There is currently 15,000 square metres in inventory, 10,000
square metres were bought for $6 per square metre and the remainder were bought for
$630 per square metre. PQR uses the weighted average basis to value its inventory.
The current market price of Material A is $7 per square metre, and the inventory could
be sold for $650 per square metre.

3. The machine would also require 250 metre lengths of Material B. This is not a material
that is regularly used by PQR and it would have to be purchased specifically for this
work. The current market price is $10 per metre length, but the sole supplier of this
material has a minimum order size of 300 metre lengths. PQR does not foresee any
future use of any unused lengths of Material B, and expects that the net revenue from
its sale would be negligible.
4. The machine would require 500 components. The components could be produced by
HK, another company within the M group. The direct costs to HK of producing each
component is $8, and normal transfer pricing policy within the M group is to add a 50%
mark up to the direct cost to determine the transfer price. HK has unused capacity
which would allow them to produce 350 components, but thereafter any more
components could only be produced by reducing the volume of other components that
are currently sold to the external market. These other components, although different,
require the same machine time per unit as those required by PQR, have a direct cost of
$6 per component and currently are sold for $9 each.
Alternatively PQR can buy the components from the external market for $14 each.
5. The machine will require 1000 hours of skilled labour. The current market rate for
engineers with the appropriate skills is $15 per hour. PQR currently employs engineers
that have the necessary skills at a cost of $12.50 per hour, but they do not have any
spare capacity. They could be transferred from their existing duties if temporary
replacements were to be engaged at a cost of $14 per hour.
6. The project would be supervised by a senior engineer who currently works 150 hours
per month and is paid an annual salary of $42,000. The project is expected to take a
total of one month to complete, and if it goes ahead is likely to take up 10% of the
supervisors time during that month. If necessary the supervisor will work overtime
which is unpaid.
7. It will be necessary to hire specialist machine for part of the project. In total the project
will require the machine for 5 days but it is difficult to predict exactly which five days the
machine will be required within the overall project time of one month. One option is to
hire the machine for the entire month at a cost of $5,000 and then sub-hire the machine
for $150 per day when it is not required by PQR. PQR expects that it would be able to
sub-hire the machine for 20 days. Alternatively PQR could hire the machine on the
days it requires and its availability would be guaranteed at a cost of $500 per day.
8. PQRs fixed production overhead cost budget for the year totals $200,000 and is
absorbed into its project costs using a skilled direct labour hour absorption rate, based
on normal operating capacity of 80%. PQRs capacity budget for the year is a total of
50,000 skilled direct labour hours. PQRs latest annual forecast is for overhead costs to
total $220,000, and for capacity to be as originally budgeted.
Required:
(a) You are employed as assistant Management Accountant of the M group.
For each of the resource items identified you are to:
(i) discuss the basis of the valuation provided for each item
(ii) discuss whether or not you agree with the valuation provided in the
context of the proposed tender
(iii) prepare a revised schedule of relevant costs for the tender
document on behalf of the M group.
(15 marks)
(b) Assume that PQR successfully wins the bid to build the machine for a
selling price of $100,000 and that the costs incurred are as expected.
Discuss the conflict that will arise between the profit expected from the
project by the Board of M on a relevant cost basis and the project profit

that will be reported to them by PQR using its routine accounting

practices. Use at least two specific examples from the bid to explain the
conflict that you discuss.
(c) Discuss two non-financial matters that you consider relevant to this
decision.

(5 marks)
(5 marks)

(Marks:14)

ned above)

(Marks:16)