Fred Pearson was pleased with his new appointment as Manage ment Accountant to Woodhouse Ltd. It was his first really important job since qualifying and at the final interview he had been impressed by the progressive attitude of Mr McKay, the Managing Director.
Mr McKay had developed a thermostat for use in industrial heating systems, and had founded Woodhouse to manufacture it. This single product formed the whole of the business of Woodhouse. A similar product, however, was produced by two other companies in Britain. In spite of this competition, Wood house had achieved steady growth in sales volume and profit ability, due in no small part to Mr McKay's managerial expertise. After the May budget meeting, Mr McKay took Fred to one side and expressed satisfaction with the improvements Fred had incorporated into the accounting information system at Wood house. Mr McKay then began to outline his plans for the firm's future. He pointed out that the present rate of growth was expected to continue into the foreseeable future, and that total demand for thermostats in the industrial field had only been partially fulfilled, even though Woodhouse's competitors had, between them, the largest share of the market.
He told Fred that the board of directors had reached a critical stage in their deliberations about the future and were undecided whether to continue the present policy of gradual sustained growth, or to follow Mr McKay's recommendation, which was to seize market leadership in price and volume as soon as possible. The board, added Mr McKay, agreed that this plan would involve greater risk, but as the firm was working at full capacity now, an expansion of the present production facilities was inevitable, and if the present growth rate was to be maintained.
If a final decision were not delayed too long, any new building work which might need to be done could be completed and the new plant could be ready for operation within 18 months, which would be March 1994.
Finally, Mr McKay stated that he had asked the Marketing Department to prepare some forecasts of sales quantity and prices based on a number of possible alternatives. The study was near ing completion and would need to be evaluated financially.
Fred was then told that he would be expected to carry out the evaluation when the information from the Marketing Department became available. Within a week from the day of the conver sation, Fred received the following letter from Mr McKay.
From: N McKay
WOODHOUSE LIMITED
Internal Memo
August 1992
To: F Pearson
Subject: Expansion Plans
During our talk after the Budget meeting last week, I mentioned that the Marketing Department would soon be completing their sales forecast study.
This has now been accomplished and four alternative courses of action are possible; these are:
PLAN A
Continue operations as at present, utilizing existing facilities and producing 500,000 units (the same as the current sales level) with no change in the present selling price of £5 per unit.
PLAN B
Expand sales by 7% to 535,000 from January 1993 and maintain the present selling price of £5 per unit. The increased production demand would be met by working at weekends, which will naturally increase the cost of both operating and supervisory labour.
PLAN C
Increase output by 15% to bring annual sales up to 575,000 by a small expansion of our production facilities and reduce the selling price to £4.8 in order to sell all the units produced. This plan could commence from October 1993.
PLAN D
Carry out an intensive modernization programme as well as expanding the size of our present factory to bring production up to 600,000 units. Selling price would be reduced to £4.7 per unit so that a much greater share of the market can be captured. Modern ization should bring about substantial savings in labour costs and some reduction in material prices should be possible due to larger purchases. During modernization Plan A would have to operate.
Could you prepare a report outlining the comparative advantages/ disadvantages of each plan? Which plan would you recommend, and why? How would each alternative affect our break-even position?
I know that there are other factors to be considered apart from the pure financial ones with which we are presently concerned; could you let me have your views on this aspect too.
Mr Johnson in the Work Study Department will give you all the information you need about labour requirements, and Mr Hayes in Production Engineering possesses full details of building costs and the type of equipment we expect to use (including capital and operating costs).
If you need any further information let me know.
N McKay Managing Director
Fred got down to the task at once and produced the following analysis of the current year's profit and loss account:
| |
£
|
£
|
|
| Sales |
|
2,500,000 |
|
Direct materials
|
400,000
|
|
|
Direct labour
|
500,000
|
|
|
Prime cost
|
900,000
|
|
100%
|
|
Production overhead
|
750,000
|
|
33.3%
|
|
Factory cost
|
1,650,000
|
|
|
|
Administrative overhead
|
400,000
|
|
12.5%
|
|
Cost of finished goods
|
2,050,000
|
|
|
|
Selling and distribution
|
|
|
|
|
overhead
|
200,000
|
|
25%
|
|
Cost of sales
|
|
2,250,000
|
|
|
Profit
|
|
£250,000
|
|
The percentages on the right are Fred's estimate of the degree of variability of the items concerned in relation to sales volume.
The effect on cost of the alternative plans could not be cal culated until after discussions with Work Study, Production Engineering, etc. However, Fred expected to have all the relevant cost information available by September 1992.
Fred collected the relevant cost details of the alternative plans:
PLAN B: There would be a 10% increase in labour costs per unit because of increases in rates and bonuses to achieve the increase in production. There would also be a £20,000 per annum increase in fixed production over head due to extra pay to supervisors, service staff etc.
PLAN C: There would be no effect on costs apart from an annual increase of £100,000 in production overhead fixed costs.
PLAN D: The use of up-to-date production equipment would reduce material and labour costs per unit by 25% and 20% respectively.
Additional depreciation and production overhead would increase annual fixed costs by £260,000. The additional capital investment necessary for Plan D would be £600,000.
You are required to prepare Fred Pearson's report to Mr McKay. Your report should incorporate.
(i) The relative profitability of each option.
(ii) The break-even point and margin of safety.
(iii) Details of other information (particularly for Plan D) you consider necessary before a decision can be made on the best option.
(iv) A recommendation, with brief notes of explanation, on which plan would be most advantageous to the firm.