Question

Mugu limited is considering accepting a new order from a new client to produce 500 gas cylinders. The Chief Executive Officer presents to you a cost estimate of the order prepared by the Chief Accountant. His advice is that, any offer below GH¢ 33,870 should not be accepted.

Details of the offer is given below.

		GH¢
1	Cost of equipment	8,000
2	Depreciation of building	1,600
3	Cost of plant	800
4	Cost of labour	425
5	Hiring and overheads	16,500
6	Material cost	900
7	Mark up	5,645
		33,870

The following notes are relevant to the above cost.

1. A specialized equipment to be used in the production of the order has a historical cost of GH¢ 8,000 and a book value of GH¢3,000. If the order is not accepted, the equipment could be sold for GH¢ 2,000 now or GH¢1, 200 in two months after the order.
2. If the order is accepted Mugu limited will be compelled to rent a temporary space elsewhere to store old materials at the cost GH¢ 1,200. The allocated depreciation of the building to be used for the production is GH¢ 1,600
3. If the order is accepted Mugu Limited will required additional special scheduling plant to be hired at GH¢ 600 or manufactured internally at GH¢ 800. The manufacturing cost includes fixed and variable cost of GH¢ 300 and GH¢ 500 respectively.
4. KCA Limited will produce the order during normal working hours using 100 hours of existing skilled labour paid at GH¢ 3 per hours. Additionally, 250 casual labour hours will be required for the order at cost of GH¢ 0.50 per hour.
5. A specialized machine will also be hired for two months for the production of the order. Hiring cost is GH¢ 1,000 per month with a minimum hiring cost GH¢ 2,500. Overheads cost will increase from GH¢12, 100 to GH¢14, 000 as a result of the order. Allocated fixed cost to the order GH¢1600.
6. Materials required for the job are already in stock. They were purchased at GH¢ 900 for another job three month ago. If used for the order it will require replacement at a cost of GH¢ 1,400. Additional material costing GH¢250 will be needed to make up the difference in supply to be able to produce the order.
7. It is the policy of Mugu Limited to mark up the cost by 20%.

As a management accountant, prepare a revised cost estimate for the order based on the above additional information using opportunity cost approach.     

SOLUTION:

1. Equipment.

Relevant cost of the equipment is the loss of sale as a result of the use. The equipment could be sold now for GH¢ 2,000 or GH¢ 1,200 in two months’ time. Implying that when use on the contract ,the equipment will loss its value by GH¢ 800 (2,000-1,200) and this should be charged to the cost of the order.

Note that the historical cost is sunk and therefore irrelevant.

2. Rental.

If the order is accepted the rental of GH¢ 1,200 will not arise. So, the rental cost is direct to the decision of accepting the contract hence is a relevant cost that should be charged to the job.

Note that, the GH¢ 1,600 allocated cost do not represent cash flow but has arose due to the conventional of providing depreciation.

3. Scheduling Plant.

The relevant cost of the plant is the lower of the cost of hiring and the relevant cost of making .To make the plant cost of GH¢800 out of which GH¢300 is fixed allocated cost . whether the order is accepted or not, the company will incur GH¢300 fixed cost . So, the relevant cost of making the plant is the variable cost of GH¢ 500 and is less than the buying price and therefore it is advisable the firm manufacture instead of hiring at GH¢ 600

4. Casual labourer.
5. The skill labour will be paid for whether the order is accepted or not and therefore not relevant to the project since there are working during the normal working hours, relevant cost of labour would therefore be the additional casual labour that would be required for the order i.e. 250 hours at GH¢ .50= GH¢125
6. Hiring and overheads cost- the minimum rental cost of GH¢ 2,500 is what KCA will pay and not GH¢ 2,000 even though GH¢ 1,000 per month for two months amounts to that and only increase in overheads will be attributable to the cost of the order. The allocated overheads of GH¢ 1,600 is irrelevant since JPCAN limited will incur it whether it accepted the order or not.
7. Material cost – the relevant cost of the material is the replacement cost of GH¢ 1400.The historical cost of GH¢ 900 is a sunk cost .additional material cost of GH¢ 250 will also be paid for giving a total relevant cost of GH¢ 1,650

JPCAN LIMITED

Details of the offer is below.

		GHS             GHS
1	Cost of equipment	8,000             800
2	Depreciation of building	1,600           1,200
3	Cost of plant	800               500
4	Cost of labour	425               125
5	Hiring and overheads	16,500          4,400
6	Material cost	900          1,650
7	Mark up	5,645          1,735
		33,870        10,410

NB

In a Memo advice management on the way forward per the quotation and your analysis?

Answer 1

ANSWER	REVISED COST ESTIMATE
	( BASED ON OPPORTUNITY COST APPROACH)
	PARTICULARS	AMT. IN GHC	REMARK
	COST OF EQUIPMENT	800	(2000-1200)
	RENT	1200	additional required
	SPECIAL SHEDULING PLANT	500	variable cost
	LABOUR COST	125	(250x0.50)
	HIRE CHARGES OF SPECIALISED MACHINE	2500	additional required
	INCREASE IN OVERHEADS	1900	(14000-12100)
	MATERIAL COST	1400	Replacement cost
	ADDITIONAL MATERIAL	250	additional required
	TOTAL	8675
	MARK-UP	1735	20% OF Cost
	OFFER PRICE	10410