The Case You are a Senior Consultant for the professional service firm, BUSI 208
ID: 2336547 • Letter: T
Question
The Case
You are a Senior Consultant for the professional service firm, BUSI 2083 LLP. Your firm specializes in providing a wide variety of internal business solutions for different clients. It is your final week on the job and a Manager asks you for some help prior to your departure. Eager to leaving a lasting impression, you start reading the background information provided by the Manager.
Lesley Donovan is the controller for the East division of Explorer Ltd. Jason Conner, head of plant engineering, has just left Donovan’s office after presenting three alternatives for submission in the capital expenditure budget for the fiscal year 2014. The budget is due to the CEO in two days and therefore Donovan realizes that time is of the essence.
Conner has outlined the following alternatives to replace an outdated milling machine:
build a general purpose milling machine;
buy a special purpose numerically controlled milling machine; or
buy a general purpose milling machine.
Explorer Ltd. is a well-established company. The company was set up about 30 years ago by two brothers Dan and Kevin Thompson, in Huntsville, Ontario, to produce accessories for the automobile industry. The Central division continues to serve the auto industry, and is the largest division in the company with sales of $35 million annually. Dan’s son is now head of this division. Kevin is still active in the company and is the Chief Executive Officer (CEO). His office is located in Toronto.
The parts division supplies seals to the mining and petrochemical industry from a plant in Toronto. This division is only ten years old and until 2010 was highly profitable. As a result of the downturn in the sector of the economy, sales in 2012 were only $12 million.
The East division, located in Scarborough, is the engineering division. Full-time employees tend to work approximately 2,000 hours in the division. Regular product lines include industrial fans, industrial cooling units, and refrigeration units for industrial users. The division is highly capital-intensive and sales tend to be directly related to general economic conditions.
Each division runs independently and performance is based upon budgeted return on investment. Bonuses are paid if the budget target is achieved. Annually, each division prepares a detailed budget submission to Kevin, outlining expected profit performance and capital expenditure requests. The milling machine proposal is part of the capital expenditure request.
The 2013 pro forma income statement for East division is set out below:
Sales
$22,364,000
Cost of Goods Sold
$14,760,240
Gross Profit
$7,603,760
Selling and General Administrative Costs
$3,578,760
Allocated Costs (based on sales)
$1,677,300
Income Before Income Taxes
$2,347,700
Return on Sales – 10.5%
Return on Investment – 8.5%
Investment (Historical Cost)
$27,626,118
Jason Connor has pointed out to Donovan that the existing machine is not only outdated but maintenance costs are becoming prohibitive. Jason also noted that maintenance costs of new general purpose machines are only $26,000 while special purpose machines can save an additional $14,000 in maintenance. Also there would be a significant savings in insurance as the price for a general purpose machine would drop to $3,000 while a special purpose machine would be 67% higher than the general purpose machine. The machine has no market or salvage value and he is sure that its book value is now zero. The trouble is that he doesn’t know which proposal is best for the company. In addition to the cost and revenue date provided, Connor provided comments on each alternative below:
Build a general purpose machine:
This machine can be built by East division. The division is below capacity at present as a major contract has just been completed. The division could thus produce the machine without affecting revenue-producing activity, but it will take six months to complete. The machine is expected to last five years and have no salvage value because removal costs will probably equal selling price.
Connor believes that the division has the technical expertise to undertake the work. In 2012, the division produced a specialized drilling machine that has proven very successful. Connor pointed out that David Williams, chief engineer, loves the design challenge of new machines. Donovan sat down with Connor and produced the following cost estimates:
Material and parts
$55,000
Direct labour (DL$)
$90,000
Variable overhead (50% of DL$)
$45,000
Fixed overhead (25% of DL$)
$22,500
TOTAL
$212,500
Donovan argues that this job should also bear a proportion of administrative costs; she suggests $12,000.
Buy a special purpose machine:
The advantage of this special purpose machine is that only one operator is required and output per hour could increase by 25%. In addition, maintenance costs are significantly reduced because microchip circuitry is employed.
Connor points out that this machine is state-of-the-art and would probably mean that new work could be taken on. A numerically controlled machine required extensive training of operators. In total, 26 weeks are spent in the supplier’s factory located in Florida. While the training is going on, the supplier provides an operator to work the machine without charge. Expected costs of this training period including hotel, per diem, and travel will cost $3,000 per week, excluding the operator’s labour which is set at $15 per hour.
The machine costs $625,000, and the supplier guarantees the salvage value of $25,000 at the end of five years. It is available immediately. It is estimated the machine can generate sales of $243,750 annually at full capacity and require $19,500 in direct materials cost. While the direct material costs are equivalent, the level of sales for the general purpose machine are $48,000 lower than the special purpose machine.
Buy a general purpose machine:
The purchase price of this machine is $295,000 and cost levels associated with the machine are expected to be the same as the general purpose machine built by the company because the technology is similar. The salvage value of the machine net of removal costs, is estimated to be $5,000 in five years. It can be delivered immediately.
General comments
The required rate of return for this investment class has been set at 8% by Kevin Thompson.
Required
Prepare the budget submission to Kevin.
Evaluation
Final Exam: Major Case Analysis will be marked in its entirety out of 100. The following rubric indicates the criteria students are to adhere to, and their relative weights to the assignment overall.
Activity/Competencies Demonstrated
% of Total
Grade
Identification and Analysis of Issues (90%)
a. Issue identification
/5
b. Identification of Key Success Factors
/10
c. Identification of Alternatives
/5
d. Quantitative Analysis
/40
e. Qualitative Analysis
/30
Recommendation (10%)
a. Recommendation on course of action
/5
b. Circumvention of Potential Problems
/5
Total
/100
PLEASE RESPONSE USING THE FOLLOWING INSTRUCTIONS:
FIRST PART (90%)
Identification and Analysis of issues:
a) Issue identification:
write here why current milling machine is unacceptable
b) Identify key success factor:
write here five success factors based on the question. Like product quality, /acceptable;e return on investment etc.
c) Identification of alternatives:
Here you will find 3 alternatives and wrote all these
d) Quantitive Analysis:
Here you need to give an analysis of General Purpose Equipment Vs Special Purpose
you are found contribution margin for both by deducting all variable costs from sales.
write the following assumption while finding CM
sufficient demand for goods produced
shift day 8 hours per day therefore standard hours per year= 2.000
supervisor's salary considered fixed
Then try to find :
cost of building the General purpose machine:
(Materials + Direct labor + Variable Overhead)
Cost of buying Special Purpose Machine
(Cost + Training cost)
Cost of buying General Purpose Machine
It is given in the case.
Prepare a statement of NET PRESENt Value for the three categories
like
Build general purpose
Buy Special Purpose and
Buy General Purpose
taking the previous cost into consideration
Here find cash inflow and cash outflow ( Cost as per above and find the Net Present value
e) Qualitative Analysis
Here discuss all factors to be considered in case of
Build General Purpose Machine
Buy General Purpose Machine
Buy Special Purpose Machine
SECOND PART: 10%
a) Recommendation on the course of action
Here you need to say what happens based on your qualitative and quantitive analysis:
East Division should build its own or not give reasons
Sales
$22,364,000
Cost of Goods Sold
$14,760,240
Gross Profit
$7,603,760
Selling and General Administrative Costs
$3,578,760
Allocated Costs (based on sales)
$1,677,300
Income Before Income Taxes
$2,347,700
Return on Sales – 10.5%
Return on Investment – 8.5%
Investment (Historical Cost)
$27,626,118
Explanation / Answer
(A)
Calculation of Relevant Cost to Build a General Purpose Milling Machine
Particular
Amount ($)
Direct Material & Parts
55000
Direct Labor
90,000
Variable Overhead
45,000
Fixed Overhead
22,500
Total Cost
212,500
Note-
(1) Allocated cost of $ 12,000 is irrelevant, hence ignored.
(B)Calculation of Cost of Buying of Special Purpose Machine
Particular
Amount($)
Training period cost ( 26 weeks x $ 3000)
78,000
Buying Cost
625000
Present Value of Salvage Value ( $ 25000 x 0.68)
-17,000
Total Relevant Cost
686,000
Note-
(1)- Operator labor cost is irrelevant hence ignored.
(c)Calculation of Buying cost of General Purpose Machine
Particulars
Amount
Purchase cost
295,000
Salvage value ( $ 5000 x 0.68)
-3400
Total Relevant Cost
291,600
Choice between Buying a General Purpose and Building a General Purpose
As appearing form above (A) & (C) above relevant cost of investment is lower if General Purpose Machine is built in-house instead of buying. Hence buying of general purpose machine should be ignored.
Comparison of Budget Between Special Purpose Machine and General Purpose Machine
Particular
General Purpose Machine ($)
Special Purpose Machine ($)
Sales Revenue yearly
195,000 ( 243750 x100/125)
243,750
Maintenance Cost yearly
-26000
-12000
Net Yearly Revenue (a)
169,000
231,750
Compounding Factor (b)
5.8666
5.8666
Present Value of Annual Cash Inflow (a x b)
991,455
1394784
Initial Investment
212,500 (Manufacturing cost)
686,000
Net Present Value
778955
708784
Note-
(1)- As Net Present value is more in General Purpose Machine. hence it should be preferred over Special Purpose Machine.
(2) In House manufacturing of General Purpose Machine will take 6 month. Present value is not considered for this 6 month. However there is no effect on decision because it will increase net present value further.
(3)- Insurance cost is more in Special Purpose Machine , it is again not considered however it will lead more cost and NPV will lesser so no effect on decision.
Conclusion- In- House manufacturing of General Machine is recommended
Particular
Amount ($)
Direct Material & Parts
55000
Direct Labor
90,000
Variable Overhead
45,000
Fixed Overhead
22,500
Total Cost
212,500