Part I: Risk profile of ABC
There are several risks to which ABC Company is exposed. Based on economic issues, ABC Company is facing a challenge of running its operations is an unprogressive economic environment. This has been occasioned by the post economic crisis effects. The level of spending is yet to recover fully and hence the company may not manage its targeted business performance. The major industry issue that ABC has to deal with is the increase in competition owing to technological advancements. This competition has been brought about by an increase in efficiency due to fast manufacturing technology. ABC is facing intense competition since other players in its industry are making constant improvements in their products, and hence increasing the level of competition. The potential effect of these risks is that they may reduce the turnover of ABC Company and hence its profits and chances of sustaining its business. ABC must take on these risks since they cannot be alleviated. The option to the company is increasing its competitiveness by adopting effective technology and minimizing its costs.
Part II: ABC Cash flow preparation
Section a: Actual cash flow statement
Cash flow Statement
Direct method
Section b: Interpretation of the cash flow statementSubsection I: Information on the source of funds
Subsection II: Improvements in cash flow
Subsection III: Project financing
This project cannot be financed with cash flow from the company. This is because ABC Company will strain under such expenditure. The company has a decrease of $ 20,000 in cash in comparison to the previous year. Under these circumstances, the funds will not be adequate for the project. The current cash balance is $ 50,000 only. This cash will be required to finance other expenditures such as maintenance of machines and employee remuneration.
Subsection IV: External financing
For external funds, ABC Company should issue additional equity. This will aid the company since it will not strain its cash payments. The advantage of an equity issue for ABC Company is that no debts will require to be serviced. In this case, the company will be paying dividends only when it is sound to issue the dividends. The other advantage of such an issue is that ABC will be in a position to raise the funds required for the project without any security or covenants; as it would have been in the event of a debt issue.
Part III: Product costSection a: Product cost under absorption and variable costing
Under absorption costing, the product cost for this company will include all manufacturing costs. Under variable costing, the product cost for this company will include the variable manufacturing costs only. For absorption costing, the costs will include direct materials, direct labor and variable and fixed manufacturing overheads. The units expected to be produced are 5,000. Direct labor for the expansion project is valued at $ 4.00 per unit. This implies that total direct labor will be valued at 5,000 * $ 4.00 = $ 20,000. The direct materials will cost 5,000 * $ 5.60 = $ 28,000 given that direct materials are valued at $ 5.60 per unit. The variable overheads are valued at $ 1.00 per machine hour. This implies that ABC Company will spend 5,000 * $ 1.00 = $ 5,000. The fixed factory overheads are valued at $ 198,000. This implies that the total product cost for the expansion product under absorption costing will be $ 20,000 + $ 28,000 + $ 5,000 + $ 198,000 = $ 251,000. Costs under variable costing will be limited to direct materials and labor and variable manufacturing overhead. The total of product cost, in this case, will be $ 20,000 + $ 28,000 + $ 5,000 = $ 53,000.
Section b: Cost impact on the existing project
The cost of the existing product will be evaluated based on fixed and variable costing. The direct labor will be 80,000 * $ 2.80 = $ 224,000. The direct materials will amount to 80,000 * $ 1.30 = $ 104,000. The variable overheads will be 80,000 * $ 1.00 = $ 80,000. Fixed factory overheads will be $ 198,000. This implies that the product cost for the existing product under absorption costing will be $ 224,000 + $ 104,000 + $ 80,000 + $ 198,000 = $ 606,000. The product cost for the expansion product under variable costing will be $ 224,000 + $ 104,000 + $ 80,000 = $ 408,000. Fixed factory expenses are $ 198,000 while fixed selling expenses are $ 191,250. The difference in product costs under variable costing for the two products is $ 408,000 - $ 53,000 = $ 355,000. Since ABC Company will be producing the two products concurrently, the expansion product will make the existing product cheap by $ 198,000/ 2 = $ 99,000. This will be the impact on fixed factory expenses. The fixed selling expenses will reduce by $ 191,250/ 2 = $ 95,625.
Section c: Selling price for expansion product
If ABC Company applies absorption costing, the total cost will include fixed selling expenses. Hence, the total cost for the expansion product will be $ 53,000 + $ 191,250 = $ 244,250. Under variable costing, ABC Company will have a total cost of $ 251,000 + $ 191,250 = $ 442,250. The total cost per unit is $ 442,250/ 5,000 = $ 88.45. Including a gross margin of 40% implies that the selling price will be 140% * $ 88.45 = $ 123.83.
Section d: Contribution margins and break even points
Under absorption costing, the total cost of the existing product will be $ 606,000 + $ 191,250 = $ 797,250. The unit cost will be $ 797,250/ 80,000 = $ 9.97. Including a 40% margin will lead to a price of 140% * $ 9.97 = $ 13.96. The fixed overhead per unit is $ 198,000/ 80,000 = $ 2.475. This implies that the contribution margin for the existing product is $ 13.96 - $ 2.48 = $ 11.48. The fixed overhead per a unit of the expansion product is $ 198,000/ 5,000 = $ 39.6. The contribution margin per unit of this product is $ 123.83 - $ 39.6 = $ 84.23. The breakeven point for the existing product is $ 797,250/ $ 13.96 = 57,110 units. The breakeven point for the expansion product is $ 442,250/ $ 123.83 = 3,572 units.
Part IV: Potential investments for ABC CompanySection a: Net present value
The net present value will be found out by computing the present values of the savings in factory overhead costs. The discount rate is 12%.
Section b: Impact of straight line depreciation
Straight line depreciation for five years will imply that the depreciation per year will be $ 42,000/ 5 = $ 8,400. As far as the fixed costs are concerned, there will be an increase of $ 8,400. This is because depreciation costs will increase the costs of running the equipment. The product costs will increase since the cost of running machines has a direct impact on product costs. However, the cash flow of ABC Company will not be affected since depreciation will not represent an actual cash outflow despite the fact that it will be expenditure.
Section c: Recommendation on purchase of equipment
Purchasing the machine will have a negative impact on the cash flow of ABC Company. Based the time value of money, the results of NPV are negative. The negative impact on cash flow and the negative NPV make purchasing the machine an unwise financial decision. Therefore, I do not recommend that ABC purchases the machine.
Part V: Conclusion
Section a: Major risk factors in this project
One of the major risk factors that stand in the way of ABC Company for this project is the financial risk. This is based on the fact that there may be unforeseen expenses for the project. The impact of such expenses is that they may increase the costs of the project. The other aspect of financial risk for ABC is that inflation might occur. This may reduce sales and increase costs. The second type of risk that may affect this machine project is technical risk. This may be brought about by the lack of technically competent employees to operate the machine. The third type of risk that ABC faces is the schedule risk. The equipment may be delayed hence making it difficult to engage in production on time.
Section b: Responsibility on the project.
My responsibility is to track ABC’s expenditure and income. For this project, I have a role of ensuring that the company does not incur losses by investing in the project. I have to ensure that costs are minimized. My advice to the company is based purely on the financials of the project. I have to interact with other managers of ABC Company in order to determine ensure that the company chooses and manage its investments wisely. I have to evaluate the risks of the project and strategize on the way forward. This is the information I will forward to senior management so that they may use it in decision making.
Section c: Recommendation to CEO
I recommend that ABC Company halts its plans of undertaking this project. This is based on the fact that the project has a negative NPV. In addition, the company does not have an adequate cash flow to kick start the project. If ABC embarks on the project, there will be a cash constraint under current circumstances. The company must improve its cash position in order to launch the project in the future when the financial foundation is strong enough.
References
Linda, L. (2012). Absorption and Variable Costing. Overview of Absorption and Variable Costing, 3-4.
Mulford, C. W., & Comisky, E. E. (2005). Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance. New Jersey: John Wiley & Sons.
Townsend, P., & Tracy, S. (2012). Straight Line Depreciation . Generally Accepted Accounting Principles , 22-23.
Williams, A. (2011). How to Identify Risk Factors in Projects. Journal of Finance, 58.
Wood, M., & Watson, P. (2012). Interpretation of Cash Flow Statements. The Cash Flow Statements and Decision Making, 37-38.
