The management of M&E Ltd has just been informed by their research department that recent breakthroughs have led to the development of a new product codenamed the Tenby. The management has decided to call a meeting to discuss whether to proceed with the manufacture of the product. The financial accountant has produced the following financial information and forecasts for the product for the management to consider.
I. Development costs so far required 10,000 labour-hours at an average cost of £30 per hour. Various materials and components had to be purchased especially for the development at a total cost of £40,000.
II. The selling price of the product would be set at £390 per unit. It is expected that production and sales would be 8,000 units per annum for eight years.
III. Production of the Tenby would require three types of input.
• Component X: to be bought specially for the project at a cost of £50 per component.
• Material Y: which is used on most of M&E's projects. At present there is 4,000 kg of Material Y in stock, which was bought for £8 per kg. It could be sold as scrap for net proceeds of £4 per kg. The purchase price of Material Y is now £10.00 per kg and is not expected to rise over the period of the project.
• Material Z: for which there is no further use other than the Tenby. There is 4,000 kg of Material Z in stock, which was bought at £20 per kg. It could be sold as scrap for £8 per kg, and its current purchase price is £25 per kg, which is not expected to change over the period of the project.
Each unit of Tenby requires 2 kg of Material Y, 1 kg of Material Z and one component X.
IV. Each unit of the Tenby requires 5 labour hours. Currently labour costs are £10 per hour, but this will rise at a rate of 5 per cent per year. There is a scarcity of labour with the necessary skills and consequently all employees would have to be transferred from another of M&E's projects. The company would have to accept a loss of contribution from this project of £5 per hour (measured as sales less all variable costs including labour). However, the labour shortage is expected to last for only 2 years.
V. Other variable costs of the project will be £30 per unit.
VI. Manufacture of the Tenby will require the use of 2 machines. The first machine will be purchased specifically for the project at a cost of £4 million. It would have a residual value of £120,000 at the end of the eight years. The second machine is already owned by M&E Ltd. This machine has a written down book value of £300,000. If the Tenby is not produced, the machine will be sold immediately for £250,000. At the end of eight years it will be valueless.
Sales revenues and production costs may be assumed to be incurred on the last day of each year. The cost of capital of M&E Ltd is 8% per annum.
Discount factors at 8% are as follows:
Year Discount Factor
0 - 1
1 - 0.9259
2 - 0.8573
3 - 0.7938
4 - 0.7350
5 - 0.6806
6 - 0.6302
7 - 0.5835
8 - 0.5403
a) Calculate the worthwhileness of the Tenby on the basis of the estimates given.
(b) Discuss any other factors that would influence your decision.