Question: Company X is considering a new manufacturing plant as part of its aggressive expansion plan. Currently the management has identified two different plants that allows the company to fulfil its requirement.

28 Oct 2022,7:49 PM

 

1. Company X is considering a new manufacturing plant as part of its aggressive expansion plan. Currently the management has identified two different plants that allows the company to fulfil its requirement. However, due to constraints in the budget, the company can invest only in one plant.

 

Plant 1:

It is forecasted that this plant will require a cash investment of $700,000 at time 0 and $1,000,000 in year 1. After-tax cash inflows of $250,000 are expected in year 2, $300,000 in year 3, $350,000 in year 4 and $600,000 each year thereafter through year 10. Though the plant might be viable after year 10, the company prefers to be conservative and end all calculations at that time.

 

Plant 2:

This new plant will require a one-time investment of $1,750,000 at time 0. The plant is expected to generate after-tax cash inflows of $500,000 in the first 2 years and $725,000 each in the next 3 years. The company prefers to end all calculations for this plant in 5 years.

 

 

1. If the required rate of return is 15%, what is the NPV of the two projects? Are these two projects acceptable?
2. Calculate the IRR for both projects.
3. What is the payback period for the two projects?
4. Based on your calculations above, which plant would you recommend to the management of Company X to invest in? Justify your answer.

(20 marks)

 

2. ABC is an entity that operates in the soft toy manufacturing industry. ABC has applied to the bank where you are employed, for a long-term loan of $150 million. Your manager has asked you to carry out an analysis and prepare the supporting documentation for the next management meeting to discuss this application for a loan. Extracts from the financial statements of ABC are provided below:

 

Statement of financial position as at 30 June	2018		2019
$m		$m
Non-current assets
Property, plant and equipment	548		465
548		465
Current assets
Inventories	146		120
Receivables	115		125
Cash and cash equivalents	-		41
261		286
Total assets	809		751
EQUITY AND LIABILITIES
Equity attributable to owners of the parent
Share capital ($1 shares)	120		120
Retained earnings	353		279
Total equity	473		399
Non-current liabilities
Long term loans	90		180
Current liabilities
Payables	196		172
Bank overdraft	50		-
246		172
Total liabilities			352
Total equity and liabilities	809		751

 

 

Statement of comprehensive income for the year ended 30 June	2018	2019
$m		$m
Revenue	1,200	1,400
Cost of sales	(840)	(930)
Gross profit	360	470
Distribution costs	(40)	(45)
Administrative expenses	(130)	(120)
Profit before interest and tax	190	305
Finance costs	(11)	(15)
Profit before tax	179	290
Income tax expense	(50)	(85)
PROFIT FOR THE YEAR	129	205

 

Analyze the financial performance and financial position of ABC and recommend whether or not ABC’s application for borrowing should be considered further (Marks are available for the calculation and presentation of relevant ratios)

(25 marks)

 

3. Barbara is the managerial accountant in charge of a large furniture factory. She needs to identify whether the current year’s couch models are going to turn a profit and wants to measure the number of units they will have to produce and sell in order to cover their expenses. Her budgeted sales volume is 3000 units for the next year. Here are the production stats.

 

Total fixed costs: $500,000

Variable costs per unit: $300

Sale price per unit: $500

 

You are required to calculate the following.

1. The breakeven point in sales units
2. The budgeted profit if she sells 3000 units next year
3. The margin of safety
4. The sales required to achieve a profit of £200,000

(10 marks)

 

4. The following information is available for periods 1–6 for the ABC Company:

($)

Unit selling price                                   10

Unit variable cost                                      6

Fixed costs per each period            300 000

 

The company produces only one product. Budgeted activity is expected to average 150,000 units per period, and production and sales for each period are as follows:

 

	P1	P2	P3	P4	P5	P6
Units Sold (000s)	150	120	180	150	140	160
Units Manufactured (000s)	150	150	150	150	170	140

 

 

There were no opening inventories at the start of period 1, and the actual manufacturing fixed overhead incurred was $300,000 per period. We shall also assume that non-manufacturing overheads are $100,000 per period. Calculate the net profit at the end of each period using Marginal Costing and Absorption Costing.

(15 marks)

 

5. A small manufacturing firm is to commence operations on 1 July. The following estimates have been prepared:

July               August            September

Sales (units)                                  10                    36                   60

Production (units)                          40                    50                   50

Opening inventory (units) NIL

It is planned to have raw material inventories of $10,000 at the end of July, and to maintain inventories at that level thereafter.

Selling prices, costs and other information:

Per unit ($)

Selling price                                   900

Material cost                                  280

Labour cost                                    160

Variable overheads                       40

Fixed overheads are expected to be $5,000 per month.

Settlement terms on sales: 10 per cent cash, the balance payable the month following sale. Labour is paid in the month incurred, and all other expenditures the following month.

Calculate the following for the 3 months.

1. The budgeted cash receipts from sales
2. The Production budget together with budgeted cash payments for raw materials
3. The total of the budgeted cash payments for labour and overhead
4. The budgeted net cash flow of the firm.
5. Explain if the management should have any concerns regarding the cash flow of the firm. If so, what would you recommend them to do in such situations?

(15 marks)

 

6. Smith Company manufactures two products, Alpha and Beta, using the same equipment and similar processes. An extract of the production data for these products in one period is shown below.

 

Alpha Beta

Quantity produced (units)                                                         10,000           14,000

Direct labour hours per unit                                                            1                    2

Machine hours per unit                                                                  3                    1

Set-ups in the period                                                                    10                  30

Orders handled in the period                                                           15                  30

 

$

Overhead costs

Relating to machine activity                                                        220,000

Relating to production run set-ups                                       20,000

Relating to handling of orders                                                         45,000

285,000

 

Required

 

1. Calculate the production overheads to be absorbed by one unit of each of the products using an Activity Based Costing approach, using suitable cost drivers to trace overheads to products.

 

1. Discuss the merits and drawbacks of using an ABC system and justify whether it is worthwhile to implement an ABC system to a modern mobile phone assembly plant.

 

(15 marks)

 

Budgeting – Example Questions

1. Example:

Preparing a materials purchases budget ABC Manufactures two products, Seeta  and Teeta, which use the same raw materials, D and E. One unit of Seeta uses 3 litres of D and 4 kilograms of E. One unit of Teeta uses 5 litres of D and 2 kilograms of E.

• A litre of D is expected to cost $. 3 and a kilogram of E $. 7.
• Budgeted sales for 20X2 are 8,000 units of Seeta and 6,000 units of Teeta; finished goods in inventory at 1 January 20X2 are 1,500 units of Seeta and 300 units of Teeta, and the company plans to hold inventories of 600 units of each product at 31 December 20X2.
• Inventories of raw material are 6,000 litres of D and 2,800 kilograms of E at 1 January and the company plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X2.
• The warehouse and stores managers have suggested that a provision should be made for damages and deterioration of items held in store, as follows.

Product Seeta: loss of   50 units         Material D: loss of 500 litres   Product Teeta: loss of 100 units         Material E: loss of 200 kilograms

 

Required to Prepare a material purchases budget for the year 20X2

 

2.Example

XYZ company produces three products X, Y and Z. For the coming accounting period budgets are to be prepared based on the following information.

Budgeted sales

Product X 2,000 at Rs. 10,000 each

Product Y 4,000 at Rs. 13,000 each

Product Z 3,000 at Rs. 15,000 each

Budgeted usage of raw material

RM11                RM22         RM33

Product X                                       5                         2               –

Product Y                                       3                         2                2

Product Z                                       2                          1               3

Cost per unit of material             Rs. 500     Rs. 300         Rs. 400

Finished inventories budget      Product X        Product Y     Product Z

Opening                                           500                        800            700

Closing                                              600                      1,000          800

Raw materials inventory budget   RM11               RM22           RM33

Opening                                            21,000                10,000         16,000

Closing                                               18,000                 9,000          12,000

Product X           Product Y      Product Z

Expected hours per unit                         4                          6                    8

Expected hourly rate (labour)         Rs. 900                Rs. 900        Rs. 900

 

Required to Prepare a material purchases budget for the year 20X2

 

Ratio Analysis

 

Financial ratios can be used to examine various aspects of the financial position and performance of a business and are widely used for planning and control purposes.

 

They can be used to evaluate the financial health of a business and can be utilised by management in a wide variety of decisions involving such areas as profit planning, pricing, working-capital management, financial structure and dividend policy.

 

Ratio analysis provides a fairly simplistic method of examining the financial condition of a business.

 

A ratio expresses the relation of one figure appearing in the financial statements to some other figure appearing there.

 

Ratios enable comparison between businesses.

 

Differences may exist between businesses in the scale of operations making comparison via the profits generated unreliable.

 

Ratios can eliminate this uncertainty.

 

Other than comparison with other businesses, it is also a valuable tool in analysing the performance of one business over time.

 

However useful ratios are not without their problems.

 

Figures calculated through ratio analysis can highlight the financial strengths and weaknesses of a business but they cannot, by themselves, explain why certain strengths or weaknesses exist or why certain changes have occurred.

 

Only detailed investigation will reveal these underlying reasons.  Ratios must, therefore, be seen as a ‘starting point’.

 

Financial ratio classification

 

The following ratios are considered the more important for decision-making purposes:

 

Ratios can be grouped into certain categories, each of which reflects a particular aspect of financial performance or position.

 

The following broad categories provide a useful basis for explaining the nature of the financial ratios to be dealt with.

 

Profitability.  Businesses come into being with the primary purpose of creating wealth for the owners.  Profitability ratios provide an insight to the degree of success in achieving this purpose.  They express the profits made in relation to other key figures in the financial statements or to some business resource.

 

Efficiency.  Ratios may be used to measure the efficiency with which certain resource have been utilised within the business. These ratios are also referred to as active ratios.

 

Liquidity.  It is vital to the survival of a business that there be sufficient liquid resources available to meet maturing obligations.  Certain ratios may be calculated that examines the relationship between liquid resources held and creditors due for payment in the near future.

 

Gearing.  This is the relationship between the amount financed by the owners of the business and the amount contributed by outsiders, which has an important effect on the degree of risk associated with a business.  Gearing is then something that managers must consider when making financing decisions.

 

Investment.  Certain ratios are concerned with assessing the returns and performance of shares held in a particular business.

Profitability ratios

 

1. Return on ordinary shareholders’ funds (ROSF)

 

The return on ordinary shareholders’ funds compares the amount of profit for the period available to the ordinary shareholders with the ordinary shareholders’ stake in the business.

 

Net profit after taxation and preference dividend (if any)  X 100

Ordinary share capital plus reserves

The net profit after taxation and any preference dividend is used in calculating the ratio, because this figure represents the amount of profit available to the ordinary shareholders.

 

2. Return on capital employed (ROCE)

 

The return on capital employed is a fundamental measure of business performance.  This ratio expresses the relationship between the net profit generated by the business and the long-term capital invested in the business.  Expressed as a percentage.

 

Net profit before interest and taxation   x  100

Share capital + reserves + long-term loans

 

Note, in this case, the profit figure used in the ratio is the net profit before interest and taxation.  This figure is used because the ratio attempts to measure the returns to all suppliers of long-term finance before any deductions for interest payable to lenders or payments of dividends to shareholders are made.

 

ROCE is considered by many to be a primary measure of profitability.  It compares inputs (capital invested) with outputs (profit).  This comparison is of vital importance in assessing the effectiveness with which funds have been deployed.

 

3.       Net profit margin

 

The net profit margin ratio relates the net profit for a period to the sales during that period.

 

Net profit before interest and taxation x  100

Sales

 

The net profit before interest and taxation is used in this ratio as it represents the profit from trading operations before any costs of servicing long-term finance are taken into account.

 

This ratio compares one output of the business (profit) with another output (sales).

 

The ratio can vary considerably between types of business.

 

For example, a supermarket will often operate on low prices and, therefore, low profit margins in order to stimulate sales and thereby increase the total amount of profit generated.

 

A jeweller, on the other hand, may have a high net profit margin but have a much lower level of sales volume.

 

Factors such as the degree of competition, the type of customer, the economic climate and industry characteristics (such as the level of risk) will influence the net profit margin of a business.

4.     Gross profit margin

 

The gross profit margin ratio relates the gross profit of the business to the sales generated for the same period.

 

Gross profit represents the difference between sales value and the cost of sales.

 

The ratio is therefore a measure of profitability in buying (or producing) and selling goods before any other expenses are taken into account.

 

As cost of sales represents a major expense for retailing, wholesaling and manufacturing businesses, a change in this ratio can have a significant effect on the bottom line (that is, the net profit for the year).

 

Gross profit  x 100

Sales