Relevant Costing on the Kelmarsh Contract
Kelmarsh Engineering is bidding for a one-off contract requiring 400 kg of material Z and 120 skilled labour hours. Material Z is currently held: 250 kg in stock (originally bought at $12/kg, current replacement cost $15/kg, scrap value $8/kg) and 150 kg must be bought new. The 250 kg in stock has no other use if not deployed on this contract. Skilled labour is currently fully utilised on other profitable work generating a contribution of $22 per hour; the contract would require paying overtime at $18/hour on top of the $16/hour basic rate for the 120 hours. A supervisor earning $30,000 a year would spend 20% of her time on the contract; her role would be backfilled by a temporary at $6,000. Fixed overhead is absorbed at $9 per labour hour. The client will pay $14,000.
1. Compute the relevant cost of the contract and advise whether Kelmarsh should bid at $14,000.
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Material Z:
- 250 kg in stock, no alternative use → opportunity cost = scrap value = 250 × $8 = $2,000 (replacement cost is irrelevant since we already hold it and won't replace it).
- 150 kg to buy → 150 × $15 = $2,250.
- Material total = $4,250.
Skilled labour (120 hrs, fully utilised):
- Opportunity cost of diverting from profitable work = 120 × $22 contribution forgone = $2,640.
- The overtime premium is not an additional relevant cost in the standard treatment when labour is diverted from other work - the relevant cost is the contribution forgone. (If instead the hours were worked as overtime in addition to normal work, the relevant cost would be the overtime premium of $18/hr = $2,160. Here labour is diverted, so use the $2,640 opportunity cost.)
- Basic wage is a sunk/committed cost → excluded.
Supervisor: incremental backfill cost = $6,000 (her existing salary is committed).
Fixed overhead: absorption of $9/hr is not incremental → excluded.
Total relevant cost = 4,250 + 2,640 + 6,000 = $12,890.
At $14,000 the contract yields a relevant surplus of $1,110 - marginally acceptable, but the margin is thin and sensitive to the labour assumption. Recommend bidding only if the $22/hr contribution estimate is robust and no penalty clauses apply.
2. The client hints that if the bid is rejected, a follow-on order worth $40,000 contribution could go elsewhere. How does this change the decision, and what is the minimum acceptable price?
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The follow-on order is a relevant opportunity cost only if it is contingent on winning this bid - i.e., if winning the first contract secures the second. If so, the $40,000 contribution is an expected benefit of bidding and should be weighed against the $1,110 surplus: total expected benefit becomes far larger, strongly favouring the bid.
However, if the follow-on is speculative or would be awarded regardless, it is not relevant and should be ignored - a classic trap. Request written confirmation of the contingency.
The minimum acceptable price equals the relevant cost floor of $12,890 (assuming no strategic value). Any price above this contributes to fixed costs and profit. Given the client's hint, a price at or slightly above $12,890 can be justified strategically, but the bid should not drop below the relevant cost floor because the contract uses scarce skilled labour with a genuine $2,640 opportunity cost.