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the example is extract from textbook
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Glo co has been offered $21,000 by a prospective customer to make some purpose -built equipment.The extra costs of the machine would be $3,000 for materials.There would also be a requirement for 2,000 labour hours.Labour wages are $4 per hour,variable overhead is $2 per hour and fixed overhead is absorbed at the rate of $4 per hour.Labour ,however ,is in limited supply,and if the job is accepted,men would have to be diverted from other work which is expected to earn a contribution of $5 per hour towards fixed overheads and profit.”and one part of the answer provided is:
“It is worth thinking carefully about labour costs.The labour force will be paid $8,000 for 2,000 hours work,and variable overheads of $4,000 will be incurred no matter whether the men are employed on the new job or on other work.Relevant costs are future cash flows arising as a direct consequence of a decision,and the decision here will not affect the total wages paid,if this money is going to be spent anyway,should it not therefore be ignored as an irrelavant cost?The answer is no.”Can I know why these two cost treated as relevant cost?Thank you
You would be better watching my free lectures rather than using a textbook – I explain this in detail in my lectures on relevant costing!!
If labour is in short supply, then the relevant cost of using it on another project is the lost contribution per hour plus the labour cost per hour (and plus the variable cost per hour if it is being charged on an hourly basis).
As a tiny example, suppose currently labour being used to make a product that has a selling price of 100, a material cost of 30, and a labour cost of 10. So a contribution of 60.
Suppose each unit takes 1 hour to make.If one hour is taken for another project, the we lose the revenue of the current product (100), we save the materials on the current product (30), but we will still be paying the labour.
So the net amount lost is 100 – 30 = 70. This is the relevant cost and is always equal to the contribution plus the labour (60 + 10 = 70).If you are still unsure then you need to watch the lecture – you cannot expect me to type it all out here 🙂
The lectures are a complete free course and cover everything needed to be able to pass the exam well. If you are watching them, then the only book you need is a Revision Kit from one of the ACCA approved publisher (which is, of course, absolutely vital , whichever way you choose to study).
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