RC plc has been invited to supply sub-components for a period of four years at a price of £20,000 per annum. The costing department has produced the following data and estimates relating to the production of these sub-components.

1. Material A is in stock and has an original cost of £16,000. It was originally intended for use in a product line which has now been discontinued. The materials can either be used for the production of these sub-components (sufficient for the next four years), or disposed of immediately which will incur transport and other costs of £1,400.

2. Material B will be required for the production, the current price of which is £2,800.

3. Skilled workers will be required for the production of these sub-components. Currently there is a shortage of skilled workers. RC plc can only obtain these workers by transferring them from an existing job. This current job produces a total contribution of £8,000 per year and will terminate in one year’s time. The company expects that the labour market will improve in a year’s time. By then there will be no problem around recruiting skilled workers. The current wage for these workers (who are contracted to work in RC plc until the end of this year) is £13,000 per annum.

4. A machine which is currently lying idle will be used to manufacture these sub-components. Details of the machine are:

	£
Original cost 2 years ago	10000
Current realizable value	4000
Estimated realizable value in 4 years	1500
Estimated life `	10 years
The machine is routinely depreciated on a straight line basis over its useful life.

5. General overheads are to be allocated on the basis of 100% of skilled workers’ cost.

6. The company’s cost of capital is 10% per annum.

7. Assume all cash flows relating to revenue and costs identified in (2) and (3) arise at the end of the years to which they relate.

Required

a) Advise the management of RC plc whether this order should be accepted. Provide detailed calculations.

b) If the company can rent a machine to produce these sub-components, what is the maximum rental payment, payable at the beginning of each year, that the company would be willing to make without diminishing the original economic worth of the contract (as in part (a))?

Answer rating: 100% (QA)

a To determine whether RC plc should accept the order we need to calculate the net present value NPV of the project NPV represents the present value of cash inflows minus the present value of cash out... View the full answer