Question 18.TQ.4 : Micro Limited has some spare capacity. It is now considering...
Micro Limited has some spare capacity. It is now considering whether it should accept a special contract to use some of the spare capacity. However, this contract will use some specialist direct labour that is in short supply. The following details relate to the proposed contract:
| £000 | |
| Contract price | 50 |
| Variable costs: | |
| Direct materials | 10 |
| Direct labour | 30 |
In order to complete the contract, 4000 direct labour hours would be required. The company’s budget for the year during which the contract would be undertaken is as follows:
| £000 | |
| Sales | 750 |
| Variable costs | (500) |
| Contribution | 250 |
| Fixed costs | (230) |
| Profit | 20 |
There would be 50,000 direct labour hours available during the year.
Required:
Determine whether the special contract should be accepted.
A special contract for Micro Limited:
Budgeted contribution per unit of limiting factor for the year:
\frac{£250000}{50000} = £5 per direct labour hourContribution per unit of limiting factor for the special contract:
| £ | £ | |
| Contract price | 50000 | |
| Less: Variable costs: | 10000 | |
| Direct materials | ||
| Direct labour | 30000 | 40000 |
| Contribution | 10000 |
Therefore contribution per unit of limiting factor:
\frac{£10000}{4000 DLH } =£2.50 per direct labour hourConclusion:
The special contract earns less contribution per unit of limiting factor than does the average of ordinary budgeted work. It may be profitable to accept the contract if either it displaces less profitable work or surplus direct labour hours are available. A careful assessment should be undertaken to ascertain whether much more profitable work would be found than is the case with the contract if it will displace other more profitable contracts that could arise in the near future.