Breach of contract; alternative uses of a product made to customer specification
Grumbles Industries Ltd is a large company with widespread interests in transport. They have just completed manufacturing a motorised barge for South Coast Steel who had intended to use the barge for dumping steelmaking waste 1 kilometre out at sea. Unfortunately, South Coast Steel have just gone into liquidation, being unable to compete successfully against the other major steel manufacturer. Further, environmental legislation has just been enacted prohibiting the dumping of garbage and industrial waste in the ocean.
The costs incurred in the production of the barge were: Direct materials $100 000
Direct labour 80 000
Manufacturing overhead allocated: Variable 10 000
Fixed 20 000 30 000
Fixed administrative expenses 5 000
Total $215 000
South Coast Steel had paid a deposit of $35 000, which was non-refundable, on the overall purchase price of $350 000.
If Grumbles wished to petition as a creditor, they estimate that they would eventually receive 25c in the dollar on unrecouped production costs, after delivering the barge to the receiver.
Greg Grimshaw, an oyster farmer, has signalled an interest in buying the barge if it is modified for the oyster business. He has offered to buy the modified barge for $75 000 on delivery. Grumbles estimate that the direct cost of the modifications would be:
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Direct materials
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$15 000
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Direct labour
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10 000
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$25 000
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A third alternative is for Grumbles to convert the barge to a river ferry. River Cruises Pty Ltd have indicated an interest in acquiring another steel-hulled ferry. The additional direct costs to convert the barge to a ferry are:
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Direct materials
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$100 000
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Direct labour
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100 000
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$200 000
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Grumbles have quoted a price for the ferry of $280 000.
Variable and fixed manufacturing overhead costs are allocated at rates of
12.5% and 25% respectively of direct labour cost. Fixed administrative expenses are charged at a rate of 6.25% of direct labour cost.
Required:
(a) Calculate the contribution each of the three alternatives will make to Grumbles Industries' pre-tax profits.
(b) If River Cruises Pty Ltd tries to negotiate a lower price than $280 000 for the ferry, what is the lowest price Grumbles Industries should accept?
(c) Discuss the relevance of the costs already incurred in manufacturing the barge to the evaluation of the three alternatives examined above.