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unskilled labour hours required in a one-off contract=500hours. These are currently fully employed by Mr Smith on jobs where they produce a contribution of $2 per unskilled labour hour. Their current rate is $10 per hour, although extra could be hired at $20 an hour if necessary. The contract is to be priced on a minimum price basis.
Sir the expandable text says that the answer should be $12*500=$6000. i understand that $2*500=$1000 is for lost contrn in case where the other work is stopped. So sir should not that be the only cost for unskilled labor for new contract?
P.S. – because i feel the costs 10*500=$5000 be incurred whether they work as usual or whether they work in the contract.
Let me explain with a little example.
Suppose that the current work has a selling price of $20 per unit, a labour cost of $10 per unit, and other variable costs (e.g. materials) of $8 per units. Each unit takes 1 hours.
So the contribution per unit is $2.
If one hour is taken for a new contract then we lose one unit of current work. So we lose the revenue of $20. However we also save the materials etc. of $8. (We are still paying the labour, so no saving there).
Therefore the net amount lost (the relevant cost) is 20 – 8 = $12. This will always be equal to the lost contribution (2) plus the labour cost (10).Dear Sir,
Thank you for this explanation
Could you please also explain why the approach for materials differs:
– in case of scarce material only lost contribution is taken as relevant cost.Building upon your example – the current work has a selling price of $20 per unit, a labour cost of $10 per unit, and materials of $8 (say 1 kg) per unit. So the contribution per unit is $2.
Let this 1 kg of material be in stock, $8 being the purchase price. It cannot be replenished for some reason.
If 1 kg of material is taken for a new contract then we lose one unit of current work:
– So we lose the revenue of $20.
– However we also save the labour cost of $10.
– $8 aleady paid for inventory is not a future cash-flow either way – hence no difference between decision options.
– Net benefit forgone is 10 (which is in turn equal to cost of material 8 + contribution 2)Thanks a lot,
Anna
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