Question 7.E.1: Lombard Ltd has been offered a contract for which there is a...
Lombard Ltd has been offered a contract for which there is available production capacity. The contract is for 20,000 identical items, manufactured by an intricate assembly operation, to be produced and delivered in the next few months at a price of £80 each. The specification for one item is as follows:
| Assembly labour | 4 hours |
| Component X | 4 units |
| Component Y | 3 units |
There would also be the need to hire equipment, for the duration of the contract, at an outlay cost of £200,000.
The assembly is a highly skilled operation and the workforce is currently underutilised. It is the business’s policy to retain this workforce on full pay in anticipation of high demand next year, for a new product currently being developed. There is sufficient available skilled labour to undertake the contract now under consideration. Skilled workers are paid £15 an hour.
Component X is used in a number of other sub-assemblies produced by the business. It is readily available. 50,000 units of Component X are currently held in inventories. Component Y was a special purchase in anticipation of an order that did not in the end materialise. It is, therefore, surplus to requirements and the 100,000 units that are currently held may have to be sold at a loss. An estimate of various values for Components X and Y provided by the materials planning department is as follows:
| \underline{ Component } | ||
| X | Y | |
| £/unit | £/unit | |
| Historic cost | 4 | 10 |
| Replacement cost | 5 | 11 |
| Net realisable value | 3 | 8 |
It is estimated that any additional relevant costs associated with the contract (beyond the above) will amount to £8 an item.
Required:
Analyse the information and advise Lombard Ltd on the desirability of the contract.
Lombard Ltd
Relevant cost of undertaking the contract is:
| £ | |
| Equipment cost | 200,000 |
| Component X (20,000 × 4 × £5) | 400,000 |
| Any of these components used will need to be replaced. | |
| Component Y (20,000 × 3 × £8) | 480,000 |
| All of the required units will come from inventories and this will be an effective cost of the net realisable value. | |
| Additional cost (20,000 × £8) | \underline{ 160,000} |
| \underline{1,240,000} | |
| Revenue from the contract (20,000 × £80) | \underline{1,600,000} |
Thus, from a purely financial point of view the project is acceptable. (Note that there is no relevant labour cost since the staff concerned will be paid irrespective of whether the contract is undertaken.)