Question 9 F5 BPP Text Exam Question Bank

AB produces a consumable compound X, used in the preliminary stage of a technical process that it installs in customers’ factories worldwide. An overseas competitor, CD, offering an alternative process which uses the same preliminary stage, has developed a new compound, Y, for that stage which is both cheaper in its ingredients and more effective than X.

At present, CD is offering Y only in his own national market, but it is expected that it will not be long before he extends its sales overseas. Both X and Y are sold separately to users of the technical process as a replacement for the original compound that eventually loses its strength. This replacement demand amounts to 60% of total demand for X and would do so for Y. CD is selling Y at the same price as X ($64.08 per kg)

AB discovers that it would take 20 weeks to set up a production facility to manufacture Y at an incremental capital cost of $3,500 and the comparative manufacturing costs of X and Y would be :

X Y
$ per kg $ per kg
Direct materials 17.33 4.01
Direct labour 7.36 2.85
—— ——
24.69 6.86

AB normally absorbs departmental overhead at 200% of direct labour : 30% of this departmental overhead is variable directly with direct labour cost. Selling and administration overhead is absorbed at one-half of departmental overhead.

The current sales of X average 74kgs per week and this level (whether X of X or of Y if it were produced) is not expected to change over the next year. Because the direct materials for X are highly specialised, AB has always had to keep large inventories in order to obtain supplies. At present, these amount to $44,800 at cost. Its inventory of finished X is $51,900 at full cost. Unfortunately, neither X nor its raw materials have any resale value whatsoever : in fact, it would cost $0.30 per kg to dispose of them.

Over the next three months, AB is not normally busy and, in order to avoid laying off staff, has an arrangement with the trade union whereby it pays its factory operators at 65% of their normal rate of pay for the period whilst they do non-production work. AB assesses that it could process all its relevant direct materials into X in that period, if necessary.

There are two main options open to AB :
i) to continue to sell X until all its inventories of X (both of direct materials and of finished inventory) are exhausted, and then start sales of Y immediately afwards;
ii) to start sales of Y as soon as possible and then to dispose of any remaining inventories of X and/or its raw materials.

REQUIRED :
(a) Recommend with supporting calculations, which of the two main courses of action suggested is the more advantageous from a purely cost and financial point of view
(b) Identify three major non-financial factors that AB would need to consider in making its eventual decision as to what to do

THE ORIGINAL ANSWER BY BPP :
(a) Full cost of production per kg of X
$
Direct materials 17.33
Direct labour 7.36
Production overhead (200$ of labour) 14.72
——-
39.41

The quantity of inventory-in-hand is therefore $51,900/$39.41 = 1,317kg
At a weekly sales volume of 74kg, this represents 1,317/74 = about 18 weeks of sales
It will take 20 weeks to set up the production facility for Y, and so inventory in hand of finished X can be sold before any Y can be produced. This finished inventory is therefore irrelevant to the decision under review; it will be sold whatever decision is taken.

The problem therefore centres on the inventory in hand of direct materials. Assuming that there is no loss or wastage in manufacture and so 1kg of direct material is needed to produce 1kg of X then inventory in hand is $44,800/$17.33 = 2,585 kg

This would be converted into 2,585 kg of X, which would represents sales volume for 2,585/74 = 35 weeks.

If AB sells its existing inventories of finished X (in 18 weeks) there are two options :
(i) To produce enough X from raw materials for 2 more weeks, until production of Y can start, and then dispose of all other quantities of direct material – ie 33 weeks of supply

(ii) To produce enough X from raw materials to use up the existing inventory of raw materials, and so delay the introduction of Y by 33 weeks.

The relevant costs of these two options :
(i) Direct materials : The relevant cost of existing inventories of raw materials is $(0.30). In other words the ‘cost’ is a benefit. By using the direct materials to make more X, the company would save $0.30 per kg used.

(ii) Direct labour : It is assumed that if labour is switched to production work from non-production work in the next three months, they must be paid at the full rate of pay, and not at 65% of normal rate. The incremental cost of labour would be 35% of the normal rate (35% of $7.36 = $2.58 per kg produced)

Relevant cost of production of X $
Direct materials (0.30)
Direct labour 2.58
Variable overhead (30% of $14.72) 4.42
——–
Cost per kg 6.47

Relevant cost per kg of Y $
Direct materials 4.01
Direct labour 2.85
Variable overhead (30% of 200% of $2.85) 1.71
——-
Cost per kg 8.57

(Note. Y cannot be made for 20 weeks, and so the company cannot make use of spare labour capacity to produce any units of Y)

It is cheaper to use up direct material inventories and make X ($6.70 per kg) than to introduce Y as soon as possible, because there would be a saving of ($8.57 – $6.70) = $1.87 per kg made.

AB must sell X for at least 20 weeks until Y could be produced anyway, but the introduction of Y could be delayed by a further 33 weeks until all inventories of direct material for X are used up. The saving in total would be about $1.87 per kg x 74 kg per week x 33 weeks = $4,567.
——————————————————————————————————–

Above is the answer of BPP for part (a) but actually I can’t get what they meant.

Why not start producing X (using up remaining direct materials of $44,800) at the same time as selling out the finished X of $51,900 and setting up production facility for Y, so that AB could introduce Y earlier ?

What they meant was AB had to sell out the finished X first for 18 weeks, and then at week 19, begin producing X to use up remaining direct material for another 35 weeks !

And also I don’t understand how they came to the point that relevant labour cost of producing 1 kg of X is (35% of $7.36). AB only had the arrangement with the trade union for the next 3 months (12 weeks) but during the next 12 weeks, there is actually no production work of X taking place, according to their plan : production of X only takes place at week 19 !

Somebody please make it clear for me. Thanks 🙂