Page 78 - P1 Integrated Workbook STUDENT 2018

Chapter 5

 A machine bought for $30,000 four years ago. The machine is currently
being used elsewhere in the business where it generates a present value
of $20,000; it has a scrap value of $12,000. A similar replacement
machine could be purchased for $15,000 and would have a zero residual
value after the conversion project.

 The project will take place in a factory which is currently empty. The
factory is being depreciated and depreciation for the duration of the
project will be £10,000.

 The conversion project will be allocated a share of central overheads
calculated at a rate of £4 per skilled labour hour worked.

In making a decision on whether to convert the product, determine the
relevant cost of the following:

 the consultants fee

 the depreciation charge

 the machine

 the central overheads.

Solution

Consultant’s fee

This is an example of a committed cost. It cannot be avoided whether the
project goes ahead or not. It is therefore not relevant to the decision on
whether to convert or not. The relevant cost is $0.

Depreciation charge

This is not a cash flow. Non-cash items are not relevant for decision making.
The relevant cost is $0.

Machine

The historic cost of $30,000 is an example of a sunk cost. Sunk costs are not
relevant for decision making.

The fact that the machine is being used elsewhere is an example of an
opportunity cost. Using the machine in the project removes the opportunity of
using the machine elsewhere.

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