TrinJam (TJ) is a company building eco-friendly houses using energy saving techn

Question

TrinJam (TJ) is a company building eco-friendly houses using energy saving technology. TJ has been asked to provide a quotation to build a pilot house in a housing development. Management of TJ believes that securing the contract will help to launch their houses and have agreed to quote a price for the house that will exactly cover its relevant cost.

The following information has been obtained in relation to the contract:
1. The Chief Executive recently met with the potential client to discuss the house. The meeting was held at a restaurant and TJ provided food and drinks at a cost of $375.

2. 1,200 kg of Material Z will be required for the house. TJ currently has 550 kg of Material Z in its inventory purchased at a price of $58 per kg. Material Z is regularly used by TJ in its houses and has a current replacement cost of $65 per kg. The resale value of the Material Z in inventory is $35 per kg.

3. 400 hours of construction worker time are required to build the house. TJ’s construction workers are paid an hourly rate of $22 under a guaranteed wage agreement and currently have spare capacity to build the house.

4. The house will require 90 hours of engineer time. TJ engineers are paid a monthly salary of $4,750 each and do not have any spare capacity. In order to meet the engineering requirement for the house, TJ can choose one of two options:

(i) Pay the engineers an overtime rate of $52 per hour to perform the additional work.
(ii) Reduce the number of engineers’ hours available for their existing job, the building of Product Y. This would result in lost sales of Product Y.
Summary details of the existing job the engineers are working on:
Information for one unit of Product Y

Sales revenue $4,860
Variable costs $3,365

It takes 30 Hrs to produce a unit of product Y
5. A specialist machine would be required for 7 weeks for the house build. TJ has 4 weeks remaining on the 15 week specialist machine rental contract that cost $15,000. The machine is currently not in use. The machine can be rented for an additional 15 weeks at a cost of $15,250. The specialist machine can only be rented in blocks of 15 weeks.
Alternatively, a machine can be purchased for $160,000 and sold after the work on the house has been completed for $140,000.

6. The windows required for the house have recently been developed by TJ and use the latest eco friendly insulating material. TJ produced the windows at a cost of $34,950 and they are currently the only ones of their type. TJ were planning to exhibit the windows at a house building conference. The windows would only be used for display purposes at the conference and would not be for sale to prospective clients.
TJ has had assurances from three separate clients that they would place an order for 25 windows each if they saw the technology demonstrated at the conference. The contribution from each window is $10,450. If the windows are used for the contract, TJ would not be able to attend the conference. The conference organisers will charge a penalty fee of $1,500 for non-attendance by TJ. The CEO of TJ can meet the clients directly and still secure the orders for the windows. The meetings would require two days of the CEO’s time. The CEO is paid an annual salary of $414,000 and contracted to work 260 days per year.

7. The house build requires 400kg of other materials. TJ currently has none of these materials in its inventory. The total current purchase price for these other materials is $6,000.

8. TJ’s fixed overhead absorption rate is $37 per construction worker hour. 9. TJ’s normal policy is to add a 12% mark-up to the cost of each house.

Required:
(a) Produce a schedule that shows the minimum price that could be quoted for the contract to build the house.
Your schedule should show the relevant cost of each of the nine items identified above. You should also explain each relevant cost value you have included in your schedule and why any values you have excluded are not relevant.
(16 marks)

(b) Explain TWO reasons why relevant costing may not be a suitable approach to pricing houses in the longer term for TJ.
(2 marks)

(c) Recommend, with justifications, a pricing strategy for TJ to use to price the innovative, eco-friendly houses when they are launched. (2 marks)

Suggested Approach

Part (a)
Carefully read the question to understand the relevant cost impact of each item of information. For each item, 1 to 9, you were required to show the relevant cost along with an explanation of their treatment of the costs. A clear layout and full explanation of cost treatment were required.
Part (b)

You need to explain two reasons why relevant costing may not be a suitable approach to pricing houses in the longer term and relate their explanation to the scenario.
Part (c)

Justified recommendations were required. The recommendation must be specific and relevant to the innovative environmentally friendly houses produced by TJ explained. Explanations of unrelated pricing strategies would not earn marks.

Explanation / Answer

(a)

Notes:

1. Cost of food and drink are sunk cost because meeting with client has already occurred and therefore the costs not relevant.

2. Material Z is regularly used by TJ. 550kg which is currently in inventory will need to be replaced and therefore should be valued at replacement cost, $65 x 550kg = $35,750. Remaining 650kg required for the contract is not available with TJ and will need to be purchased at the replacement cost, $65 x 650 = $42,250. Total relevant cost $78,000

3. Construction workers have spare capacity and are employed under a guaranteed wage agreement. They will be paid whether or not they work on the contract; therefore the cost is not relevant.

4. Engineers are on salaried basis which is fixed in nature. However, they are currently at full capacity and do not spare time. Engineer's additional time should be valued at opportunity cost. If overtime is paid, the cost would be 90 hours x $52 = $4,680. If switching engineers from their existing job: 90 hours / 30 hours to produce = 3 units of product Y valued at contribution per unit $1,495 ($4,860 - $3,365) = $4,485. The lower cost of the two options is $4,485 and this is the relevant cost.

5. Existing rental period is left with only 4 weeks, $15,000 has already been paid, this is a sunk cost and not relevant. Another 15 week rental agreement would have to be entered into, therefore the relevant cost is $15,250. If the machine was to be purchased, the relevant cost would be $20,000 (sales price less resale value). The lower of the two options is to rent the machine, hence relevant cost is $15,250.

6. Cost to produce windows has already been incurred and is therefore a sunk cost. If TJ use the windows for building house and misses the conference, the sales will still not be lost. The CEO can visit the clients at a later date to secure the sales; therefore there is no incremental loss in contribution. The CEO time is not relevant as he is paid an annual salary and would receive this irrespective of the visit to the clients. Its only the penalty which is an incremental cost and therefore a relevant cost $1,500.

7. 400kg of other materials required for the house, relevant is $6,000.

8. Fixed costs are not relevant as they will be incurred irrespective of contract is awarded or not.

9. Profit mark-up is not relevant as TJ is provising a minimum quote to exactly cover all its relevant cost only.

(b) When quoting a minimum price for a contract, relevant costing principles are generally used where only those costs that changes as a direct result of contract decision are included in the quoted cost. The minimum price will result in TJ making neither a profit nor a loss. Relevant costing is not a sustainable pricing policy in longer term because (1) it does not include contribution to the fixed costs of the organisation and (2) it does not include a profit margin.

(c) Market skimming would be a suitable pricing strategy to launch the houses. IT charges a high price for the product initially where the product is unique and there are significant barriers to entry for the competitors. The price is reduced as new competitors enters the market with similar product. The strategy aims to maximise the profit from the product. The high quality materials and unique energy saving technology used in the houses should command high prices from customers keen to have a house with this technology. The house that consumers are willing to pay a high price for, together with the barrier to competitors of the new energy saving technology, make TJ’s product suited to the market skimming pricing strategy and it allow TJ to recover the research and development costs incurred to develop the energy saving technology

Cost items: Amount ($) Refer Note Food & drink cost at Meeting $0 1 Material Z $78,000 2 Construction workers $0 3 Engineers $4,485 4 Specialist Machine $15,250 5 Windows $1,500 6 Other Materials $6,000 7 Fixed overhead $0 8 Profit Margin $0 9 Total Relevant Cost $105,235

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