Question

Grass Eaters, a manufacturer of lawn mowers, predicts that it will purchase 264,000 spark plugs next year. Grass Eaters estimates that 22,000 spark plugs will be required each month. A supplier quotes a price of $7.00 per spark plug. The supplier also offers a special discount option: if all 264,000 spark plugs are purchased at the start of the year, a discount of 4% off the $7.00 price will be given. Grass Eaters can invest its cash at 10% each per year. It costs Grass Eaters $250 to place each purchase order.

3 of 9 (0 complete) at it wil chased Requirements quotes a Grass El gone st forg 1. What is the opportunity cost of interest forgone from purchasing all 264,000 units at the start of the year instead of in 12 monthly purchases of 22,000 units per order? 2. Would this opportunity cost be recorded in the accounting system? Why? 3. Should Grass Eaters purchase 264,000 units at the start of the year or 22,000 units each month? Show your calculations 4. What other factors should Grass Eaters consider when making its decision? Print Done

Answer 1

Solution:

1.

If Grass eaters purchases all 264000 at the start of year

	Numbers	price per unit	Cost
Purchase cost	264,000.00	$6.72 (7-4%)	$1,774,080
Order cost	1	$250	$250
Total cost			$1,774,330

If Grass eaters purchases 22000 for 12 months

	Numbers	Price per unit	Cost
Purchase cost	264,000.00	$7	$1,848,000
Order cost	12.00	$250	$3,000
Total cost			$1,851,000

Opportunity cost = Return from foregone option-Return from chosen option

= ($1,851,000*10%)-($1,774,330*10%)

=$7667 is the opportunity cost of interest foregone

2. Opportunity cost is the profit lost when one alternative is selected over another. The concept is useful simply as a reminder to examine all reasonable alternatives before making a decision. Opportunity cost is not an accounting concept, and so does not appear in the financial records of an entity. It is strictly a financial analysis concept. Hence it would not be recorded in the accounting system.

3. As per point 1 above

Total cost If Grass eaters purchases all 264000 at the start of year is $1,77,4330 + $7667 (opportunity cost) = $1,781,997

Total cost If Grass eaters purchases 22000 per month for 12 months is $1,851,000

In view of lesser cost, Grass eaters should purchase all 264,000 at the start of year.

4. Other factors to be considered :

a. Availability of sufficient funds: Grass eaters should be sufficiently funded to pay for all 264,000 spark plugs at one go. It should not be the case that Grass eaters has to avail credit or loan for the same since it could result in additional costs in which case the options would need to be re-evaluated.

b. Estimation of demand: Grass Eaters should be able to make an accurate estimation at the start of the year whether it will need the 264,000 units of spark plugs.