PART I: MAJOR RISK FACTORS
- Interest rates: The economy is experiencing fluctuation in interest rates on mortgages. ABC produces cedar roofing and siding shingles hence it is in the housing industry. The demand for housing is largely influenced by interest rates since most people buy and construct houses using mortgages. High interest rates increase the cost of mortgages and lower the demand for housing (Smart & Megginson, 2008). With low demand for the company’s products, the planned expansion may result in losses.
- High competition: There is intense competition in the industry as the number of firms has grown considerably. This leads to a reduction in the company’s sales as some of its customers may switch consumption to the products of competitors. In addition, ABC may be forced to invest heavily in product promotion and other marketing activities thereby increasing its cost of production. High costs of production limit the ability of the proposed expansion to achieve its intended goals.
- Other risks which may affect the product include adverse changes in factors that influence demand such as consumers’ income, unfavourable regulations, and fluctuations in exchange rates, among other risks. Others include increase in the cost of inputs, increase in taxation and disruptions in the supply chain.
PART II: CURRENT COMPANY CASH FLOW
- Cash flow statement (Direct method)
Sales 1,200,000
Decrease in Accounts Receivable 60,000
Total Cash collections 1,260,000
Less:
Cost of goods sold 800,000
Increase in inventory 70,000
Increase in Accounts payable (40,000)
Cash payment for purchases (830,000)
Income tax expense 30,000
Increase in income tax payable (30,000)
Cash paid for income tax -
Cash paid for operating expenses
Selling and administration expenses (250,000)
Net cash flow from operating expenses 180,000
Cash from investment activities
Purchase of equipment (100,000)
Net cash flow from investment activities (100,000)
Cash flows from financing activities
Payment of dividends (100,000)
Net cash flow from financing activities (100,000)
Net cash flows during the year (20,000)
Cash balance at the beginning of the year 70,000
Cash balance at the year-end 50,000
- Analysis of cash flows
- Sources and uses of funds
As indicated by the cash flow statement, the only source of cash for ABC Company is sales. This cash is mainly used in paying for purchases and selling and administration expenses. The company also made a purchase of equipment worth $100,000 and paid dividends amounting to $100,000. All these payments were financed by cash flows from operating activities as well the balance of cash carried forward from the previous year.
- Ways to improve cash flows
One of the ways ABC Company can improve its cash flow is by increasing its sales. Sales are the sole source of funds for the company hence its increase will result in an increase in cash flow from operating activities. This can be done through increased expenditure on advertising as well as research and development. In addition, the company should reduce its high levels of inventory. High levels of inventory reduce the amount of cash in the company as stock held in inventory ties the company’s capital. Among measures to reduce the level of inventory is implementing a Just-In Time stock system. In this system, inventory ordered in such a manner that it arrives at the company’s premises when it is required. This will increase cash in the company as amount that could be tied in inventory will be available for other uses.
Furthermore, the company could use a more conventional system or matching policy for managing its assets. Under this system, long term investments should be financed by long-term sources of finance. ABC Company’s cash flow statement indicates that it used cash from operating activities to finance the purchase of an asset (non-current) worth $100,000. Since the returns from the asset are expected over a long period of time, using cash from operating activities reduces cash availability in the company (Smart & Megginson, 2008). ABC should finance non-current assets using either equity funds or long-term borrowing.
Finally, ABC Company can improve its cash flow by employing a conservative dividend policy. It should pay less in dividends and focus on increasing investment for future profitability. In the current year, ABC paid a total of $100,000 on dividends, more than 80% of its after tax profit. A residual dividend policy would be appropriate to ensure that dividends are paid only when all profitable investment opportunities have been exploited.
- This project cannot be financed by current cash flow. As indicated, the company had a balance of $50,000 in cash at the year-end. The project requires $42,000 to purchase new equipment. If current cash is used to finance this project, the company will be left with inadequate cash to finance its operating activities. The project can only be financed through long-term borrowing or issuance of new equity.
- Debt v. Equity
PART III: PRODUCT COST
- Product cost under variable and absorption costing
Absorption Costing
$
Direct materials 5.60
Direct labour 4.00
Variable factory overhead (1.00 × 5,0005,000 machine hours) 1.00
Variable selling expense 0.20
10.80
Add fixed costs
Fixed factory overhead {198,000/ (80,000+5,000)} 2.33
Fixed selling overheads {191,250/(80,000+5,000)} 2.25
Total cost per unit 15.38
Total cost = $15.38 × 5,000 units
= $76,900
Variable Costing
Direct materials 5.60
Direct labour 4.00
Variable factory overhead 1.00
Variable selling overhead 0.20
Total cost per unit 10.80
- Total fixed cost absorbed by the new product
Fixed factory overheads (2.33 × 5,000) 11,650
Fixed selling overheads (2.25 × 5,000) 11,250
Total fixed overheads absorbed 22,900
Cost absorbed per unit of current product = 22,90080,000
= 0.28625
Current product cost is reduced by $0.28625
- Selling Price
Product cost (Variable costing) 10.80
Profit margin (40% × 10.80) 4.32
Selling price 15.12
- Break-even Analysis
- Contribution margins
Current product Expansion Product
Selling price 14.50 15.12
Variable cost (4.80) (10.80)
Contribution margins 9.70 4.32
Break-Even Point = Total Fixed CostAverage Contribution Margin
Total fixed cost = 198,000 + 191,250
= $389,250
Average contribution margin = 80,00085,000×9.70+5,00085,000×4.32
= 9.13 + 0.25
= 9.38
BEP = 389,2509.38
= 41,498 units
BEP per Product
Current product = 80,00085,000×41,498
= 39,057 Units
Expansion product = 5,00085,000×41,498
= 2,441 Units
PART V: Potential investments to accelerate profit
- Net Present Value of the proposed investment
- Impact of the proposed investment on the factory fixed costs
The proposed investment will lead to a decline in fixed factory overheads for the first 4 years of the project’s economic life as shown in the above table. During that period, savings on fixed factory overhead costs are expected to be less than the additional annual cost of depreciation for the new equipment. On the fifth year, ABC Company will experience an increase in its fixed factory overhead costs because the amount of savings in cost is less than additional depreciation of the equipment for the year.
Impact on implied product costs
Since factory overhead costs form part of the product costs, a reduction in overhead costs as indicated above will result in a reduction in the cost of the two products. During the fifth year, product cost will increase. However, if the company is using variable costing, the cost per unit of the product will not change since variable costing ignores fixed costs of production in determining product cost. Fixed factory overheads will be treated as period costs.
Impact on cash flow
In the first year, the proposed investment will lead to a reduction in the company’s net cash flow since the company will incur $42,000 in purchasing the new equipment. From the second year, onwards, there will be an increase in cash flow due to the savings brought on factory overhead costs. Even in the final year, there will be an increase in cash flow despite the savings being less than the addition depreciation cost. Depreciation is a non-cash expense hence it has no bearing on the company’s cash flows (Shapiro, 2004). Considering the time-vale of money, the overall effect of this proposed investment will be a reduction in cash flow since the cash inflows from the project are less than its discounted cash outflows.
- Recommendation
PART V: CONCLUSION
The responsibility of the management accountant in this proposed investment is to provide the management with relevant information and advice. This involves identifying and assessing the major risks facing the investment. In addition, the accountant identifies the costs and benefits associated with the project. The management accountant also assesses the viability of the proposed investment and advices the management on whether to invest in the project or not (Smart & Megginson, 2008).
Based on the above analysis, the project is likely to face major risks which will adversely affect the amount of sales the company makes. The analysis also reveals that the proposed investment is not viable since it has a negative NPV and adverse effects on the company’s cash flows. The CEO should not invest in the project.
References
Brigham, F. E., & Houston, F. J. (2009). Fundamentals of Financial Management. New
York: Cengage Learning.
Shapiro, C. A. (2004). Capital Budgeting. London: Prentice Hall.
Smart, B. S., & Megginson, L. W. (2008). Corporate Finance. New York: Cengage
Learning.
