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A company is evaluating a project that requires 4,000 kg of a material that is used regularly in normal production. 2,500 kg of the material, purchased last month at a total cost of $20,000, are in inventory. Since last month the price of the material has increased by 2½%.
3. What is the total relevant cash flow arising from using the material for the project?
A.$12,300
B.$20,500
C.$32,300
D.$32,800The correct answer is D.
Since the material is used regularly, the relevant cost is the replacement cost (i.e. the cost of buying the material today). The price last month was $8 per kg (20,000 ÷ 2,500). The price is now $8.2 per kilo (8 × 1.025). Relevant cost of 4,000 kg is therefore $32,800.
My question:
2500 kgs of materials were already purchased in the past and past costs are sunk costs, not relevant cash flow. The relevant cash flows will only be on the remaining materials of 1500 kg left to be purchased. Why have they consider the purchase of entire 4000 kgs of material cost as relevant cash flows?The material is in regular use. So the 2,500 kg that are in inventory would be used in the regular production if it was not used for this project. Using it in this project will mean that it will have to be replaced in order to be able to continue with their normal production.
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