Question

Relevant Costing 20 Marks Question 1 Study the scenario and complete the questions that follow: Pearson Ltd Pearson Ltd is a manufacturer of high quality tools. The company produces, besides 120 000 units per annum of a certain spare part that is frequently used in the manufacture of various tools. One hundred thousand (100 000) of these spare parts are used internally in the manufacture of tools, and 20 000 are sold to external manufacturers at a price of R15 per unit. The profit made on the sale of the 20 000 units is used to reduce the cost of 100 000 units. The company has been approached by a sales representative of another manufacturing company, offering to provide the company with theses spare parts at a price of R13 per unit, provided that at least 100 000 units are purchased per annum. The following information regarding the section manufacturing this spare part has been extracted from the budget for the year ending 30 June 2018. Material @ R1,50 per unit Labour @ R30 per hour Overheads Total cost @ R17.50 per unit 180 000 720 000 1 200 000 2 100 000 Overheads consist of the following: • Sectional overheads: R900 000 Sectional overheads are 60% fixed, 50% of which are committed fixed costs. • Overheads of the enterprise R300 000 Overheads of the enterprise comprise fixed managerial and administrative costs, which are allocated to the various sections on the basis of labour hours. This particular production section manufactures only the abovementioned spare part. Source Hunde T.2020 COMA221A - Tako-Home Assessment C2 2020V1.0 Page 3 of 10 Required: 1.1 Determine whether Pearson Limited should continue selling 20 000 units of the spare part to external manufacturers annually: If the spare part is manufactured. (4 Marks) If the spare part is purchased (3 Marks) a b.

Answer 1

In calculating the marginal cost of producing the spare parts, the following fixed costs are not considered as they are sunk cost and will have to be paid irrespective of whether the company continues or discontinues the production of the spares:

1. Enterprise overheads of R 300,000

2. Committed sectional overheads of R 270,000

Therefore, marginal cost of producing spare parts is calculated as below -  

Units	100,000	120,000
Material @ R1.5 per unit	150,000	180,000
Labour @ R 6 per unit (Note 1)	600,000	720,000
Overheads (Note 2)
Fixed	270,000	270,000
Variable @ 3 per unit	300,000	360,000
Total cost	1,320,000	1,530,000
Cost per unit	13.20	12.75

Conclusion:

a. If the spare is manufactured, the company should continue producing and selling 20,000 parts to external manufacturers as producing additional parts reduces the price per unit and the selling price of R15 is more than the cost of producing those.

b. If the spare part can be purchased at R13 per unit and sold at R15 per unit, the company should continue selling the parts to external manufacturers.

Note 1:

Labour for 120,000 units = R 720,000. Therefore, labour per unit = R 6

Note 2:

Total Overheads = 1,200,000

Less Enterprise OH = 300,000

Sectional OH = 900,000

Variable @ 40% = 360,000 for 120,000 units (R 3 per unit)

Fixed @ 60% = 540,000

Committed (not considered) @ 50% = 270,000

Considered Fixed = 270,000