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Hello Sir hope you are doing well.
I have a question regarding “Choice of Contract” question which is in the kit of Kaplan.The following is the extract of the question
“A company in the civil engineering industry with headquarters located 22 miles from London undertakes contracts anywhere in the United Kingdom.
The company has had its tender for a job in north-east England accepted at $288,000 and work is due to begin in March 20X3. However, the company has also been asked to undertake a contract on the south coast of England. The price offered for this contract is $352,000.
Both of the contracts cannot be taken simultaneously because of constraints on staff site management personnel and on plant available. An escape clause enables the company to withdraw from the contract in the north-east, provided notice is given before the end of November and an agreed penalty of $28,000 is paid.
Req As the management accountant to the company present comparative statements to show the net benefit to the company of undertaking the more advantageous of the two contract
There is a specific point, in the question which states. “The plant which would be needed for the south coast contract has been owned for some years and $12,800 is the year’s depreciation on a straight-line basis. If the north-
east contract is undertaken, less plant will be required but the surplus plant will be hired out for the period of the contract at a rental of $6,000”.Sir the suggested answer has taken $6000 as a relevant (opportunity cost) in case the contract on South Coast is accepted. Which i totally understand.
However, shouldn’t this $6000 also be an incremental benefit/revenue for contact at North East England under the comparative statement .
As in case North East Contract is undertaken, less plant would be needed a s surplus plant will be hired out for the period.
You are happy that $28,000 is the penalty payable if you go for South-coast and withdraw from North-east. And the same thing applies to the North-east contract if you don’t undertake it so the $6,000 is an opportunity cost it could be hired out. Agreed
The question states that both contracts cannot be undertaken simultaneously because of the constraints on staff site personnel and on plant availability. It is one of the other!
So you can’t look at it from any other perspective than as an opportunity cost of $6000 South-coast or income for North-east. Not both.
In this case if income for North-east
NE 288,000 – 199,600 + 6000 = 94,400
SE 352,000 – 264,400 = 87,600
Diff is still 6,800Thankyou for your response Tutor. But i think there are some typing error in your answer which is making it difficult for me the understand your explanation.
My Approach to this question was that i looked at each of the contract at a time along with their relevant cash flow.
That i first saw the relevant cash flow from the North East Contract and then i saw the relevant cash flow from South Coast Contract. Because of which this problem arised.
Can you please tell me the approach to use because of which this problem does not arise. Thankyou in Advance:)
The question states that both contracts cannot be undertaken simultaneously because of the constraints on staff site personnel and on plant availability.
Therefore an opportunity cost for $6000 South-coast which you agreed with
or you could look at this as income to the North-east.
In this case if there is income for North-east
NE 288,000 – 199,600 + 6000 = 94,400
SE 352,000 – 264,400 = 87,600
Diff is still 6,800
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