Question

Reilly Ltd has been approached by a customer who is willing to pay £88,000 for a special job. The job would require the following materials: Material Total units required Units in stock Book Value of units in stock (per unit) Realisable Value (per unit) Replacement Cost (per unit) A 2,000 0 - - £14.00 B 2,000 1,200 £4.00 £5.00 £12.00 C 2,000 1,400 £6.00 £5.00 £10.00 D 400 400 £8.00 £12.00 £18.00 Notes: Material B is regularly used by Reilly in the manufacture of their standard products. If units of B are used for this job they would need to be replaced. Materials C and D are specialist materials in stock due to previous overbuying and they have a restricted use. No other use can be found for material C. The stock of material D could be used in another job as a substitute for 600 units of material E. Reilly has no stock of material E at present but it can be bought locally for £10 per unit. Book value is the cost of stock as recorded in the accounting system. Realisable value is the amount the stock would fetch if sold unused. REQUIRED Calculate relevant costs to decide whether or not this contract should be undertaken. Include an explanation as to why a cost is relevant, and therefore included, or not relevant, and therefore excluded from calculations.

Answer 1

Reilly Ltd should undertake the special job as the total relevant costs of £84,600 are less than the revenue of £88,000, resulting in a profit of £3,400.

Step-by-step explanation:

To decide whether or not Reilly Ltd should undertake the special job with a customer willing to pay £88,000, we must calculate the relevant costs. Only costs that will be directly impacted by the decision should be considered, meaning costs that will occur if and only if the project is accepted. Such costs are sometimes called incremental costs or differential costs and do not include sunk costs or costs that will remain the same whether the project is undertaken or not.

Material A requires 2,000 units with none in stock, so the relevant cost will be 2,000 units × £14/unit = £28,000. Material B is in stock (1,200 units) but is regularly used in production; thus, its opportunity cost, which is the replacement cost, is relevant. So, the cost for Material B is 800 units (as 1,200 are in stock) × £12/unit = £9,600. For Material C, with 2,000 units needed and 1,400 in stock, the material cannot be used elsewhere, so the relevant cost is the realisable value, not the book value or replacement cost. Therefore, 600 units at £10/unit = £6,000, plus the realisable value of surplus stock (1,400 units × £5/unit = £7,000). Material D is a bit more complex since it can substitute another material, E, which costs £10/unit. We need 400 units of D, the realisable value of which exceeds the cost of material E; therefore, we should sell D at £12/unit and purchase E instead, leading to a relevant cost for D of 400 units × £10/unit = £4,000.

Adding these together, we calculate the total relevant cost as: £28,000 + £9,600 + £6,000 + £7,000 + £4,000 = £84,600. Since the revenue from the job is £88,000, the profit for undertaking the job would therefore be £88,000 - £84,600 = £3,400. Thus, it would be financially beneficial for Reilly Ltd to accept the job.