Question 14

T Limited is an engineering company that specializes in building engines for grinding machines. One of the components for building these engines is sourced from K Limited, a company in the same group with T Limited. Each component is being transferred to T Ltd, taking account of K Ltds opportunity cost of the component. The variable cost of K Ltd is GHS280 per component. A prospective customer has approached T Ltd to submit a quotation for a contract to build a new engine. This is a new customer to T Ltd but directors of T Ltd are keen on winning this contract as they believe that may lead to more contracts in the future. As a result of this, they intend pricing the contract using relevant costs. The following costs data is given in respect of the contract:

1. The production director of T Ltd is on an annual salary equivalent to GHS15,000 per 8-hour day;
2. The materials needed for the contract are:
   • 110 square metres of material A. This material is normally being used by T Ltd and it has 200 square metres in stock. These were bought at a cost of GHS120 per square metre. They have resale value of GHS105 per square metre and replacement cost is GHS125 per square metre.
   • 30 litres of material B. This material has to be purchased specially for this contract and the minimum order quantity from the supplier is 40 litres at a cost of GHS90 per litre. T Ltd has no use for this material after the contract is executed. Sixty (60) components will be purchased from K Ltd at a purchase price of GHS500 per component.
3. A total of 240 direct labour hours will be required. The current wage rate for the grade of labour that will work on the contract is GHS110 per hour. T Ltd currently has 75 direct labour hours of spare capacity for this grade and are being paid under collective wages agreement. The additional hours required will be sourced by either overtime at a cost of GHS140 per hour; or employment of temporal staff at a cost of GHS120 per hour. But this temporary staff, because they are not experienced, will require 10-hour supervision by existing supervisor who would be paid overtime at a rate of GHS180 per hour for this contract.
4. 25 hours would be required. The machine to be used is already leased at a weekly lease rental of GHS6,000. It has 40 hours per week capacity. The machine has sufficient available capacity to complete the contract. The variable cost of running the machine is GHS70 per hour.
5. The companys fixed overhead absorption rate is GHS200 per direct labour hour.

You are required to:

1. Calculate the relevant cost of building the new engine and explain why you have included or excluded any costs in your calculation.
2. Discuss the factors that would be considered by K Ltd to determine the opportunity cost of the component.