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Hi , I’m a bit confused with this question from Kaplan exam kit:
H has inventory of 15000 kg of M, a raw material which is bought for £3/kg 5 years ago, for a product line which was discontinued 4 years ago. M has no use in its existing state but could be sold as a scrap for £1/kg. One of the company’s current products HN requires 4 kg of raw material, available for £5 per kg. M can be modified at a cost of £0.75 per kg so that it may be used as a substitute for this material. However , after modification , 5 kg of M is required for every unit of HN to be produced.
H has now received an invitation to tender for a new product which could use M in its present state.
What is the relevant cost per kg of M to be included in the cost of estimate for the tender.?
Many thanks in advance,
Cost of HN unit using bought in material=4×5=20 per unit
cost of using modified M=0.75×5=3.75
Overall cost saving per item HN = 20-3.75=16.25
per unit HN Produced.3000 able to be produced with existing M inventory.Saving from using M to produce
HN by modification is 16.25 x 3000=48750
Alternative use of selling for scrap yields 15000×1=15000
48750-15000=33750
33750/15000=2.25
This means if my calculations are correct that 2.25 should be used as starting basis for material relevant cost for tender.Per kg for tender=2.25
When dealing with relevant costs you need to make sure when considering the relevant cost whether it all of the following things-
1.A cash flow
2.avoidable
3.A future cost
You must also determine the potential next best usage -the opportunity cost of taking a certain action.In above case processing M means it will be unavailable to sell for scrap.However,overall the organisation will be better off as long as there is adequate demand for HN.Hi ,
Many thanks for the reply, first of all I do not understand why we have to take 4×5 = £20 into account when we can use the existing product M ?
I assumed:
cost of using existing inventory M, 5 x £0.75= £3.75 , but if it was to be sold We would have made £1 x 5= £5 so the difference is the relevant costing ?apologies, don’t really get it.
Basically, it is to do with best of the alternative uses for the product.This can be in form of revenue raised,cost saved or a combination of both.The 4 x 5 calculation is relevant because if we did not have the product this would be cost of producing HN.
Bearing in mind what I have written in previous posts,the following choices exist-
1.Keep the material.This can be ruled out since there is no clear financial or strategic upside indicated in the question.
2.Sell the material for scrap.This yields 15000 but if sold for scrap it can’t be used as a substitute material for making HN.
3.Substitute material and use to make HN.If this saves more than 15000 it should be done.
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