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Hi, I am struggling with this question and any help will be greatly appreciated.
UU Company has been asked to quote for a special contract. The following information about the material needed has been given:
Material X
Book Value – £5.00 per kg
Scrap Value – £0.50 per kg
Replacement Cost – £5.50 per kgThe contract requires 10kgs of material X. There are 250kgs of this material in inventory which was purchased in error over 2 years ago. If material X is modified, at a cost of £2 per kg, it could then be used as a substitute for material Y which is in regular use and currently costs £6 per kg.
What is the relevant cost of the materials for the special contract?
Please do not simply type out questions and expect me to provide an answer. You must have an answer in the same book in which you found the question, and so you should ask about whatever it is in the answer that you are not clear about. Then I will explain.
Given that material X was bought in error, it is therefore presumably not used by UU company. Therefore, it is was not used as a substitute for Y it would be sold for $0.50 per kg..
Therefore if it used as a substitute for Y, there is an opportunity cost of the lost scrap of $0.50 and there is also the cost of modifying it of $2.00. Therefore the relevant cost if it is used as a substitute for Y is $2.50 per kg..
UU has the choice of either buying Y at $6 per kg, or using X which costs $2.50 per kg..
Since using X is cheaper, they will use X and the relevant cost is $2.50 per kg..
I suggest that you watch my free lectures on relevant costing. The lectures are a complete free course for Paper PM and cover everything needed to be able to pass the exam well.
The solution says:
“There is no intention to replace material X. There are 2 options for material X, scrap at a value of 50p per kg or use as a replacement for material Y, which would save £4 per kg (£6 – £2). The latter is the preferable option so the relevant cost is £4 per kg.”
The solution has not taken into account the lost scrap value of 50p – but even with this included, it does not give the £2.50 which you have calculated above.
Please can you explain further which is correct, and whether there is an error with the solution.
Oops – I read your original question too quickly (and thought it was Y that was needed for the contract. Sorry 🙁
I will start again 🙂
If they do not use X for the contract then they have the choice of either selling it for 0.50, or paying $2 to use it as a replacement for Y, which will save them a net $4 (6 – 2).
Therefore they would prefer to use it as a replacement for Y and save $4.If instead, they use X for the contract, then they will not be able to use it as a replacement for Y and will not therefore save $4. Therefore the relevant cost of using X in the contract is indeed $4.
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