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If we have the material in inventory then we have two scenarios:
1) Material is in regular use of the company
Relevant cost = Purchase cost2) Material is not in regular use of the company
Relevant cost = Opportunity cost
Higher of: (1) Scrap value (2) Alternative useAn alternative use is the net incremental cash flow and it is actually the net benefit/cost from alternative use.
Alternative use could have several different meanings like:
a) lost contribution foregone due the existing material are used on a one-off relevant contract.b) using existing material by modifying it instead of purchasing a new material from the market.
c) net incremental cash flow which could be either be net benefit or net cost cash flow.
There is simply no fixed rule for opportunity cost calculation in the relevant costing rather it depends on the information given in the question. (correct?)
Please say what I’ve written is correct?
In this question, we have given two choices either to modify material X and use it instead of material Y or simply buy the material Y from the market.
UU company has been asked to quote for a special contract. The following information about the material needed has been given:
The contract requires 10 kgs of material X. There are 250 kgs of this material in inventory which was purchased in error over two years ago. If material X is modified at a cost of $2 per kg then it could be used as a substitute for material Y which is in regular use and currently cost $6 per kg.
This is how our calculation goes like:
Purchase cost of material Y = 10 kgs x $6 = $60
modified cost of material X = 10 kgs x $2 = $20
Net cost saved————————————–$40Could you please tell me whether the net incremental cash flow is the net benefit or net cost? According to me it is a net cost saving of $40 (in other words it is a net benefit actually) but how it is relevant cost then? Please explain.
If the material is not used in the contract then they would use it instead of material Y and save $40.
If they use it in the contract then they will not save $40. Therefore if they use it in the contract they are losing the saving of $40 so it is an opportunity cost of doing the contract.
Hello sir. I have read this thread and understood the concept which you are trying to say. Basically we take the relevant cost as the higher of the scrap value or the gain we could have made from choosing to convert the material into a regularly used material. Can you please confirm this understanding by solving this problem?
Ajanta company is calculating the relevant cost of the material to be used on a particular contract. The contract requires 4,200 kgs of material MOMO and this can be bought for $6.30 per kg. The company bought 10,000 kgs of material MOMO some time ago when it paid $4.50 per kg. Currently 3,700 kgs of this remains in inventory. The inventory of material MOMO could be sold for $3.20 per kg.
The company has no other use for material MOMO other than on this contract, but it could be modified it at a cost of $3.80 per kg and use it as a substitute for material JOJO. Material JOJO is regularly used by the company and can be bought for $7.50 per kg.
What is the relevant cost of the material for the contract?If they did not use the material in the new contract then they would have the choice of either scrapping it and receiving $3.20 per kg, or using it instead of material MOMO in which case they would save a net $3.70 per kg (7.50 – 3.80). They would choose to use it instead of material MOMO and save $3.70.
If they use it in the contract they would not make this saving and there will therefore be a relevant cost (an opportunity cost) of $3.70 per kg..
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