Question 12.10: PDH Ltd, small firm of building contractors, has, on your ad...
PDH Ltd, small firm of building contractors, has, on your advice, prepared a budget for the next year and is aiming to increase output in an effort to improve profits. The actual results for last year have been finished and both sets of figures are given below.
| Actual
$’000 |
Budget
$’000 |
|
| Sales | 1,800 | 2,250 |
| Direct costs | ||
| Materials | (800) | (1,000) |
| Labour | (400) | (500) |
| (1,200) | (1,500) | |
| Gross profit | 600 | 750 |
| Factory production overheads | (200) | (210) |
| 400 | 540 | |
| Administration and general overheads | (280) | (330) |
| Profit | 120 | 210 |
The company has been asked to tender for a contract at a time when work is scarce and staff may have to be laid off. In addition, the output to date is well below the level hoped for, being nearer to last year’s actual than this year’s budget. Because of this, the CEO has prepared his quotation by using overhead recovery rate based on actual proportions achieved last year. The quotation is given below:
| $’000 | |
| Direct costs | |
| Materials | 150 |
| Labour | 60 |
| 210 | |
| Factory overheads—one sixth of direct costs | 35 |
| 245 | |
| Administration overheads—one-fifth of factory cost | 49 |
| 294 | |
| Profit—one-fourteenth of total cost but reduce to | 6 |
| Price tendered | 300 |
You ascertain that the materials have been priced at cost and include the following:
1 Special window frames which cost $8,000, but are unlikely to be used and have a disposal value of $3,000. Alternatively, they could be converted for use on this contract at a labour cost of $2,000; otherwise, frames costing $7,000 must be purchased.
2 Timber which cost $10,000 but would now cost $18,000 to replace.
In order for you to be able to consider this, it is necessary that you understand the system of overhead recovery implicit in the quotation and the basis on which the quotation was prepared. Knowing this might lead you to revise the quotation.
The problem with the figures shown is that they reflect the assumption that overheads will be based on same kind of average—quite arbitrary—sharing of overheads. Actual overhead costs may be quite different. A revised quotation should be prepared to reflect expected costs.
A further factor is that the contract has come at a time of low demand, so there will be no opportunity cost—lost contribution—for labour. The company is short of work and may have to lay off labour. Under these circumstances, any job that makes a contribution has to be considered carefully. The contribution of the job being tendered for can be calculated by comparing the relevant cost (as shown below) with the price quoted. The revised statement should be something like:
| $’000 | $’000 | |
| Materials | 150 | |
| Less | ||
| the cost of windows which have a lower opportunity cost plus the opportunity cost of the windows used. Either: | (8) | |
| (a) If used, the scarp value will be lost | 3 | |
| A further labour cost will be incurred | 2 | |
| 5 | ||
| or (b) Replacement frames could be purchased | 7 | |
| The lower cost option should be used, so | ||
| Timber | 5 | |
| The opportunity cost of using the material, which had cost $10,000 but which would cost $18,000 to replace, is $18,000, so the increased cost ($10,000 is already included) is | 8 | |
| Materials cost | 155 | |
| Labour—actual cost | 60 | |
| 215 |
Determining how the various overheads behave is difficult, but worth consideration. In the figures shown above, it is presumed that the overheads will not change just by taking on this job, so there are no relevant cost increases. In practice, this may not be the case, and a sound understanding of how costs behave is essential. Any price in excess of this would leave the business better off by taking on the contract.
The original quotation reflects the kind of price that should be charged if PDH Ltd is to be fairly confident of recovering its overheads and making a profit. The confidence is justified only if total revenues and general cost levels are in line with the budget. In a time of low demand, the probability of being able to recover the overheads is seriously reduced. Trying to recover overheads in a competitive market might prove impossible. The decision comes down to what the market will bear in price, and how much the job is needed by PDH Ltd. In a case like this, the reality is that taking on the contract at any price above $215,000 will minimise loss rather than avoid losses altogether.