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Dear Mr Moffat,
the following is the example:Direct materials – $3
Direct labour – $4
Variable overhead – $1
Specific FC – $2.50
Other FC – $2The company uses 12000 units. If labour were not used to manufacture the units it would be used to increase production of another component for which there is unlimited demand. This other item has contribution of $10 and requires $8 of labour hr.
Question is : What is the most price per component at wich buying is preferable to internal manufacture?
In the answer they sum up all the costs but it is explained that Relevant cost is Contribution forgone + Direct labour ($10 / 2 + $4)=$9
Could you please tell me, do we divide 10 over 2 because we have two time less labour hr ($4 in compare with $8)?
Is it somehow related with $2 of other fixed costs? but in what way?
Then, I can’t understand why this $2 is not included into calculations.
Answer is $15.50
We don’t know the labour rate per hour (and it doesn’t matter what it is) but just suppose it is $4 per hour. That would mean that the new project needs 1 hour per unit.
They are taking the hours from another product which must be taking 2 hours per unit ($8/$4) and therefore every hour taken must be losing contribution of $10/2 = $5.
Therefore the total relevant cost per hour is 4 + 5 = $9
Sir, many thanks for such clear explanation. I understand now. By the way, with what frequency the participants may ask questions here? I ‘ve once read, it’s not good to ask again and again.
I don’t know where you read that! Ask as many questions as you want (assuming that you have watched our free lectures first) – just make sure you start a new thread when it is a different topic.
Ok, thank you.
Sir, I have just feel a bit confused by what they say in the example: “If labour were not used to manufacture the units it would be used to increase production of another component for which there is unlimited demand.” Wouldn’t it be more correct to say something like: The additional hours might be taken from manufacturing of another component? Or, if to follow their text, it might be said, that we lose $5 because our first product’s labour capacity might be used to produce the alternative component, but in this case our 1 hr will produce only half of contribution.
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