Question

A firm operates in manufacture of lysine for industrial use. Lysine sells in a perfectly competitive industry for $35.00 per ton produced. The costs of raw materials such as sugars, water, gas and electricity and labor average to $29.00 per ton. These costs can be avoided by shutting down. The cost of the lease on machinery, the building, and the shipping vehicles average an additional $8.50 per ton; costs that would take a longer time to terminate based on the long-term contracts involved. Based on this information, what is the best course of action for the firm?

Answer 1

Answer:

Continue the production of Lysine until the cost of leasing machinery, the building, and the shipping vehicles becomes avoidable.

Explanation:

We will use relevant costing here to assess whether we must close the production of Lysine or not.

According to relevant costing principles if the cost is relevant then it must satisfy following conditions:

• Must be cash flow in nature.
• Must be Future related (no past commitments).
• Differential or must be incremental

Clearly cash would be used here and the cost or income arising must not be linked to the past bindings, it must be future related. The third condition is very interesting here, the concept of differential.

A differential cost will arise if we take the decision (closing down production of Lysine), and it will not arise if we don't take the decision (closing down production of Lysine).

All the variable costs will be relevant which means that variable cost of $29 per ton is relevant. Variable costs are also known as avoidable cost which means unavoidable costs will not be relevant here.

Here, unavoidable costs are $8.5 per ton and are unavoidable.

Hence

Contribution per unit generated = $35 per ton - $29 per ton = $6 per ton

This means if we close the production of Lysine then we will suffer a loss of $6 per ton

Hence the company must continue producing Lysine until it is able to avoid cost of $8.5 per ton. In which case, the cost will become relevant and the decision will be altered to stop production.

Mathematically, (If $8.5 per ton becomes avoidable in future)

Contribution = $35 per ton - $29 per ton - $8.5 per ton = Loss of $2.5 per ton

Best Course of Action:

Continue the production of Lysine until the cost of leasing machinery, the building, and the shipping vehicles becomes avoidable.

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