Advanced Technology, Inc., (ATI) is evaluating a contract proposal calling for it to build and test bearings using a newly patented surface configuration. ATI would receive $1.4 million for the work. ATI's management believes that the bearings can be built and tested using existing facilities, with the exception of one piece of test equipment that can be rented at a cost of
$45,000. If the contract is accepted, 8000 hours of direct labor will be required. ATI calculates these labor costs at $110 per hour. This labor cost is derived by adding a 20-percent fixed overhead charge to actual direct labor costs, plus a 100-percent charge for the firm's required profit margin. The overhead and profit charges are the amounts that management believes
can be earned under normal conditions. Materials and supplies costing $250,000 will be purchased for the project, and 1,000 pounds of a specialty steel currently in inventory will be used. This steel cost $20,000 when purchased, and ATI estimates the cost of carrying the inventory since purchase at about 20 percent of initial cost. The steel has a current market value
of $18,000. Finally, management has determined that resources are currently fully employed, and acceptance of this job will require turning away other available business.
Accounting's cost projection for the bearing test job is as follows:
1. Direct labor cost
(8,000 hours @ $50 per hour) $400,000
2. Direct materials:
Purchased materials $250,000
Inventoried steel 24,000 274,000
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Total direct labor & materials 674,000
3. Equipment rental 45,000
4. Overhead (20 percent of direct labor) 80,000
5. Required profit margin
(100 percent of direct labor) 400,000
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Total project cost ' $1,199,000
Note: As pointed out above, percentages of direct labor are used as a means of estimating the contribution a job makes to overhead and profit under "normal" conditions. Remember these are financial accounting numbers. For example, numbers 4. and 5. above say little about "overhead" and "profit," since the 120% that is "typically" earned by a job with 8000 hours of direct labor, has been allocated to profit and overhead using some accounting rule. This means only that the total contribution to ATI of a job utilizing 8000 hours of direct labor is normally about 120% of direct labor charges billed.
a) Estimate ATI's economic (relevant) cost of accepting the contract.
b) How would an assumption that the economy was in a recession and that ATI didn't have enough business to keep its resources fully employed affect the relevant costs for this problem?
Be specific and re-estimate the costs of the job.
class notes and problems
economics 401
professor john m heineke
c) In parts a) and b) what are the economic profits associated with accepting the contract? What do these numbers mean?
Review: There are additional costs to consider when ATI is operating at capacity which are not relevant when there is excess capacity. A profit maximizing decision requires that the costs of the proposed contract be correctly calculated. There are two problematical types of costs here, (i) sunk costs which do not impact the return from the contract if it is accepted--in general the relevant costs associated with any project are those which change because the contract is taken-- and (ii) returns given up if the contract is accepted. Any returns that would have been earned, but will not be if the contract is accepted, are costs of accepting the contract. Therefore, whether the current operation has excess capacity or is at capacity is an important consideration.