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Reference Example 1 of page 47 of ACCA FM Notes on Relevant Cash Flows:
The question or the key issue is that if we are saving the materials cost of £ 60,000 by not taking the other project then why we are not saving the labour if the materials cost is saved by not taking the other project because ultimately the labour works on materials. Or in other words if we will pay the labour in any way then is it not implied that we are going to buy the material for the other project on which labour is utilized in any way. This view gets strenthened by the fact that the question has not mentioned anywhere that the labour is idle and if the labour is in continuous use don’t you feel that materials must also be in continuous use andfor such materials in continuous use the relevant cost is the current replacement cost or purchase price. Kindly clear the ambiguity by replying sir.
As far as the materials are concerned, they have already been purchased and therefore the 60,000 is a sunk cost. The 60,000 has been spent whether or not the project is allowed to proceed and is therefore irrelevant. All that is relevant is that if the project does not go ahead then 5,000 needs to be spent disposing of them.
The materials are not in regular use. If they were then the question would not say that they were bought for this project and that if not used in the project then they would have to dispose of them.
If the project does not continue then the labour would be used elsewhere and would generate $1500,000 sales revenue, would cost $40,000 for the labour, and would cost $60,000 for materials. (It is a coincidence that $60,000 happens to be the same amount as the material that has been purchased for the new project, but they are not the same materials for the reason that I have explained in the first paragraph. That might be confusing at first, but this example is actually a very old real exam question and the figures are all the same.As a result, if the labour is taken for the new project then they will lose the revenue of $150,000, but will save the materials of $60,000. (They will still be paying the labour of $40,000). So the net relevant cost is 150,000 – 60,000 = $90,000.
Brilliantly explained rather the best explanation I could ever had respected Sir. Cleared all the ambiguities.
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