Exercise 1

The production department of Alpha Ltd. normally operates at a capacity of 5 000 direct labor hours (DLH) per production period. In the coming production period (April-May) orders equivalent to only 3 000 DLH have been received. Even though direct labor is hired/paid on an hourly basis, Alpha Ltd. wants to deploy the available 2 000 DLH and considers two alternatives:

First alternative: advancing the production of an anticipated future order that consumes 2 000 DLH (delivery date end of July). Alpha Ltd. expects a very busy period in June-July, so by producing the future order in April-May, the production department avoids performing and paying 2 000 DLH in overtime in June-July. Overtime is paid by adding a 30% premium on the normal wage of 4 EUR/DLH. The longer storage of the early production in Alphas inventory does not cause incremental costs.

Second alternative: deploying the 2 000 DLH by accepting an exceptional, one-time order to be produced in April-May. The following resources are needed to produce the order:

Materials:

960kg of resource X. Resource X is currently in inventory with an average cost of 3.02 EUR/kg (average book value/kg). The current market price (replacement cost) of resource X equals 3.10 EUR/kg. Resource X is commonly used in the production department.

570kg of resource Y. Resource Y is currently in inventory with an average cost of 5.26 EUR/kg (average book value/kg). The replacement cost is 5.85 EUR/kg. Resource Y has no other application, but can be sold at 2.30 EUR/kg.

Other resources. These resources are not in inventory but can be bought at 3 360 EUR.

Direct labor: 2 200 DLH

Indirect costs (e.g. depreciation machines, maintenance machines, electricity costs,) are attributed to the different departments at 6 EUR/DLH. 40% of these indirect costs are variable, and consequently really vary with the number of DLH performed (e.g. if DLH are performed, machines run and maintenance and electricity costs are incurred). The other 60% of the indirect costs are fixed (e.g. depreciation costs).

QUESTIONS:

Determine the one-time offers minimal price that allows Alpha to increase profit in comparison with the other alternative (do not consider the possible interest costs and revenues as a result of different cash flow timings).

(Theory) Give, based on this specific situation, a description of the following concepts:

Sunk costs, b. Opportunity costs, c. Incremental costs