The following information has been obtained in relation to the contract:

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1 PERFORMANCE MANAGEMENT WEEK 10-QUESTIONS VARIANCE ANALYSIS CONTACT NUMBER: CONTACT DAYS: FRIDAYS AND SATURDAYS 8PM TO 9PM TOPIC: STRATEGIC RELEVANT COST - CHAPTER 8 Question 1 DLW is a company that builds innovative, environmentally friendly housing. DLW s houses use high quality materials and the unique patented energy saving technology used in the houses has been the result of the company s own extensive research in the area. DLW is planning to expand into another country and has been asked by a prominent person in that country for a price quotation to build them a house. The Board of Directors believes that securing the contract will help to launch their houses in the country and have agreed to quote a price for the house that will exactly cover its relevant cost. The following information has been obtained in relation to the contract: 1. The Chief Executive and Marketing Director recently met with the potential client to discuss the house. The meeting was held at a restaurant and DLW provided food and drinks at a cost of N ,200 kg of Material Z will be required for the house. DLW currently has 550 kg of Material Z in its inventory purchased at a price of N58 per kg. Material Z is regularly used by DLW in its houses and has a current replacement cost of N65 per kg. The resale value of the Material Z in inventory is N35 per kg hours of construction worker time are required to build the house. DLW s construction workers are paid an hourly rate of N22 under a guaranteed wage agreement and currently have spare capacity to build the house. 4. The house will require 90 hours of engineer time. DLW engineers are paid a monthly salary of N4,750 each and do not have any spare capacity. In order to meet the engineering requirement for the house, DLW can choose one of two options: (i) Pay the engineers an overtime rate of N52 per hour to perform the additional work. (ii) Reduce the number of engineers hours available for their existing job, the building of Product Y. This would result in lost sales of Product Y. Summary details of the existing job the engineers are working on: Information for one unit of Product Y Sales revenue N4,860 Variable costs N3,365 Page 1

2 Engineers time required per unit 30 hours 5. A specialist machine would be required for 7 weeks for the house build. DLW have 4 weeks remaining on the 15 week specialist machine rental contract that cost N15,000. The machine is currently not in use. The machine can be rented for an additional 15 weeks at a cost of N15,250. The specialist machine can only be rented in blocks of 15 weeks. Alternatively, a machine can be purchased for N160,000 and sold after the work on the house has been completed for N140, The windows required for the house have recently been developed by DLW and use the latest environmentally friendly insulating material. DLW produced the windows at a cost of N34,950 and they are currently the only ones of their type. DLW were planning to exhibit the windows at a house building conference. The windows would only be used for display purposes at the conference and would not be for sale to prospective clients. DLW has had assurances from three separate clients that they would place an order for 25 windows each if they saw the technology demonstrated at the conference. The contribution from each window is N10,450. If the windows are used for the contract, DLW would not be able to attend the conference. The conference organizers will charge a penalty fee of N1,500 for non-attendance by DLW. The Chief Executive of DLW can meet the clients directly and still secure the orders for the windows. The meetings would require two days of the Chief Executive s time. The Chief Executive is paid an annual salary of N414,000 and contracted to work 260 days per year. 7. The house build requires 400kg of other materials. DLW currently has none of these materials in its inventory. The total current purchase price for these other materials is N6, DLW s fixed overhead absorption rate is N37 per construction worker hour. 9. DLW s normal policy is to add a 12% mark-up to the cost of each house. Required: (a) Produce a schedule that shows the minimum price that could be quoted for the contract to build the house. Your schedule should show the relevant cost of each of the nine items identified above. You should also explain each relevant cost value you have included in your schedule and why any values you have excluded are not relevant. (17 marks) (b) Explain TWO reasons why relevant costing may not be a suitable approach to pricing houses in the longer term for DLW. (4 marks) (c) Recommend, with justifications, a pricing strategy for DLW to use to price the innovative, environmentally friendly houses when they are launched in the new country. (4 marks) Page 2

3 QUESTION 2 Mr Smith has been asked to quote a price for a special contract. He has already prepared his tender but has asked you to review it for him. He has pointed out to you that he wants to quote the minimum price as he believes this will lead to more lucrative work in the future. Mr Smith s tender Material: A 2,000 N10 per kg 20,000 B 1,000 N15 per kg 15,000 C 500 N40 per kg 20,000 D 50 N12 per litre 600 Labour: Skilled 1,000 N25 per hr 25,000 Semiskilled 2,000 N15 per hr 30,000 Unskilled, 500 N10 per hr 5,000 Fixed overheads 3,500 N12 per hr 42,000 Costs of preparing the tender: Mr Smith's time 1,000 Other expenses 500 Minimum profit (5% of total costs) 7,725 Minimum tender price 166,82 MATERIAL D 1,000 kgs of this material is in stock at a cost of N5 per kg. Mr Smith has no alternative use for his material and intends selling it for N2 per kg. However, if he sold any he would have to pay a fixed sum of N300 to cover delivery costs. The current purchase price is N10 per kg. MATERIAL B There is plenty of Material B in stock and it cost N18 per kg. N Page 3

4 The current purchase price is N15 per kg. The material is constantly used by Mr Smith in his business. MATERIAL C The total amount in stock of 500 kgs was bought for N10,000 some time ago for another one-off contract that never happened. Mr Smith is considering selling it for N6,000 in total or using it as a substitute for another material, constantly used in normal production. If used in this latter manner it would save N8,000 of the other material. Current purchase price is N40 per kg. MATERIAL D There are 100 litres of this material in stock. It is dangerous and if not used in this contract will have to be disposed of at a cost to Mr Smith of N50 per litre. The current purchase price is N12 per litre. Mr Smith only hires skilled labour when he needs it. N25 per hour is the current hourly rate. SKILLED LABOUR Mr Smith has a workforce of 50 semiskilled labourers who are currently not fully utilised. They are on annual contracts and the number of spare hours currently available for this project are 1,500. Any hours in excess of this will have to be paid for at time-and-a-half. SEMI-SKILLED LABOUR Mr Smith has a workforce of 50 semiskilled labourers who are currently not fully utilised. They are on annual contracts and the number of spare hours currently available for this project are 1,500. Any hours in excess of this will have to be paid for at time-and-a-half. The normal hourly rate is N15 per hour. UNSKILLED LABOUR These are currently fully employed by Mr Smith on jobs where they produce a contribution of N2 per unskilled labour hour. Their current rate is N10 per hour, although extra could be hired at N20 an hour if necessary. Page 4

5 FIXED OVERHEADS This is considered by Mr Smith to be an accurate estimate of the hourly rate based on his existing production. Costs of preparing the tender Mr Smith has spent 10 hours working on this project at N100 per hour, which he believes is his chargeout rate. Other expenses include the cost of travel and research spent by Mr Smith on the project. Profit This is Mr Smith s minimum profit margin which he believes is necessary to cover 'general day-to-day expenses of running a business'. Required: Calculate and explain for Mr Smith what you believe the minimum tender price should be. Page 5

6 QUESTION 3 Identify which of the following costs are relevant to the decisions specified: (a) The salary to be paid to a market researcher who will oversee the development of a new product. This is a new post to be created especially for the new product but the N12,000 salary will be a fixed cost. Is this cost relevant to the decision to proceed with the development of the product? (b) The N2,500 additional monthly running costs of a new machine to be purchased to manufacture an established product. Since the new machine will save on labour time, the fixed overhead to be absorbed by the product will reduce by N100 per month. Are these costs relevant to the decision to purchase the new machine? (c) Office cleaning expenses of N125 for next month. The office is cleaned by contractors and the contract can be cancelled by giving one month s notice. Is this cost relevant to a decision to close the office? (d) Expenses of N75 paid to the marketing manager. This was to reimburse the manager for the cost of travelling to meet a client with whom the company is currently negotiating a major contract. Is this cost relevant to the decision to continue negotiations? Page 6