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Dear Sir,
I am confused about how to judge a cost is relevant or not for a decision.
When I was doing the example 2 question from chapter 9 of the OT F5 notes, I thought the machine overheads (from notes 5) should be $3 X 4000 hours + $2 X 2000 hours. The definition I learned from the textbook is that only costs that alter as a result of a decision are relevant. Therefore I think the displaced 2000 machine hours is an irrelevant cost, since whether you take the special order or not, it´s gonna happen anyway. If you do not take the special order you will use the 2000 hours to produce your normal products, so the only relevant costs are the extra 4000 hours and the opportunity cost from losing contribution.
Could you please explain what´s wrong with my logic here? It would be very helpful to me! Thank you!Let me invent some figures to hopefully make it clear.
The existing job gives a contribution of $2 per hour. Although we are not told (and do not need to know) how this was calculated, just suppose the existing job takes 1 hour to make, has a selling price of $10, material cost of $5, and machine overheads of $3.
So…the contribution is $2. (Again, apart from mating overheads and contribution, these are invented figures).If we take one hour from this job, then I do agree – we will be paying the overheads whatever happens. However, if we do take the hour, then we will lose the revenue of $10 and we will save the materials of $5.
So….the opportunity cost is 10 – 5 = $5 per hour. (i.e. the contribution before charging the machine overheads, or the contribution + the machine overheads)I hope that helps.
Thank you for the detailed explanation! Brilliant! It all makes sense now!
It´s been very helpful! Thank you again! Wish you a nice evening!
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