MN20501 Workshop 4: Relevant Costs

EatNatural Ltd is a company which specializes in the manufacture and sale of

health foods. The company has just completed market research on a new
type of organic toothpaste called Dr Organic. The budget estimate derived
from the market research for one year’s production and sales, which was
presented to the board by the marketing manager, is as follows:

£ £
Cost of production (100,000 kg)
Labour
Direct wages 50,000
Supervisory 50,000
100,000
Raw materials
Ingredient X 17,000
Ingredient Y 7,000
Ingredient P 9,000
Ingredient Z 1,000
34,000
Other variable costs 10,000
Fixed overheads (60% of direct labour) 30,000
Research & development 20,000
Total costs 194,000

Sales (100,000 kg at £1.60 per kg) 160,000

Loss (34,000)

The board of directors are very disappointed with this budget in view of the
research and development costs already incurred of £20,000 and the need to
make use of the spare capacity in the factory. Fred Sharp, the managing
director, suggests bringing in a consultant to examine the costs of the new
product.

The following additional information is available.

(i) 60% of the direct labour required would be transferred from another
department within the company. The monthly contribution of this department
is currently £5,000 and would fall by only 20% of its current level as a result of
the reduction in the labour force. The remainder of the direct labour
requirement would have to be recruited. It is anticipated that their wages will
be the same as those transferred from the other department. In addition, it is
estimated that the cost of recruitment will be £3,000.

(ii) Two supervisors would be required at a cost of £25,000 per year each.
One would be recruited externally; the other, Reg Raven, would remain at
work instead of retiring. The company will pay him a pension of £10,000 per
year on his retirement.

MN20501 Workshop 4 1
(iii) Inventories of ingredient X are currently available for a whole year’s
production of Dr Organic, and are valued at their original cost. The price of
this ingredient is subject to dramatic price variations, and the current market
price is double the original cost. It could be resold at the market price less
10% selling expenses or retained for use later in another new product to be
manufactured by the company, by which time it is expected that the market
price will have fallen by about 25%.

(iv) Ingredient Y’s price has been very stable and is used for other products
currently manufactured and sold by the company. There is currently no spare
inventory available for the production of Dr Organic.

(v) Ingredient P is another commodity with a fairly stable price. Half of the
annual requirement is in inventory and the other half will have to be
purchased during the year at an estimated cost of £4,500. The materials in
inventory could be resold for £4,000 less 10% selling expenses, or could be
used to produce another product after some further processing. This
processing would save the company additional purchasing costs of £5,000.
The processing would take 2000 hours in the mixing department where labour
is paid £12 per hour; the mixing department has sufficient idle capacity to
carry out this work.

(vi) Ingredient Z was bought well in advance and is held in inventory. It has no
alternative use. Fred Sharp is beginning to regret the decision to buy this
ingredient in advance as it will deteriorate in store and may become
dangerous before the end of the budget period. It cannot be sold and will cost
the company £500 to dispose of it if it is not used to produce Dr Organic.

(vii) The other variable costs can all be avoided if the contract is not accepted.

(viii) Fixed overheads of the company are expected to increase by £2,000 per
year as a result of manufacturing and selling Dr Organic.

Required:
As the consultant employed by the company, you are requested to re-
examine this statement, taking account of the additional information, and to
recommend any necessary action. Clearly explain your treatment of each
cost.

MN20501 Workshop 4 2