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John Moffat.
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Syed Ahsan Ali
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Please do correct me if I am wrong anywhere relating to relevant cost.
If we have material in stock then we have only two situations to consider such as:
1) If material in stock is regularly USED then [RC = Current Purchase Price] since we need to purchase material on current market price.
2) If material in stock is not regularly USED then [RC = Opportunity cost] because we will look whether the material has any alternative use like use it for another project and if it has not alternative then we simply sell it scrap [RC = Scrap value]
BUT in case of questions which involved modification cost of the material and then use it for the contract then what would be the relevant cost?
Is it also true that opportunity cost is the lost contribution foregone because we are losing the contribution that we would have earned by using the material in another project?
John Moffat
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(1) and (2) are correct.
If modification is needed then the cost of modifying is an extra relevant cost.
If using the material does result in losing sales of an existing product, then the lost contribution is a relevant cost.
Have you watched my free lectures on relevant costing?
Syed Ahsan Ali
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[Question]
A company is calculating the relevant cost of the material to be used on a particular contract. The contract requires 4200 kgs of material H and this can be bought for $6.30 per kg. The company bought 10,000 kgs of material H some time ago when it paid $4.50 per kg. Currently 3700 kgs of the remains in inventory. The inventory of material H could be sold for $3.20 per kg.The company has no other use for material H other than on this contract, but this could be modified it at a cost of $3.70 per kg and use it as a substitute for material J. Material J is regularly used by the company and can be bought for $7.50 per kg.
[My doubts]
Here we are considering whether the 3700 kgs held in inventory which has no other use other than this new contract; so we do have two choices here such aseither:
1) we can sell the 3700 kgs in scrap at a cost of $3.20
or
2) we can use 3700 kgs of material H in new contract rather than on another project as a substitute for material J; so in this case, we do save $3.80 (7.50 – 3.70) because we are modifying the material H at a cost of $3.70 to use it on another project for the material J but we are also saving the cost $7.50 of buying the material J. So, the Net Benefit from alternative use is $3.80.But I have a problem regarding my doubt (2);
First, let me know whether the Net Benefit from Alternative use is the Lost contribution or not?Secondly, we are only considering the costs saved of $3.80 which is the opportunity cost because if the company does not use the material H in the new contract; then it will only have one best alternative that they will use material H as a substitute for material J which will result in saving the cost of $3.80 (which is Net Benefit for Alternative Use)?
Please correct me if I am incorrect anywhere!
John Moffat
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The relevant cost is $3.80 because this is opportunity cost of not using it to modify as a substitute for material J.
Although that is indeed the relevant cost, do not call it the contribution because it is not the contribution. (Contribution is revenue less variable costs)
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