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Capital Budget Long Term Financing Decisions

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  • Course Code: ACCT19060
  • University: CQ University
  • Country: Australia

Discuss About The Capital Budgeting Long Term Financing Decisions.

 

Answer:

Introduction

In the given scenario the management of the company is to decide whether to launch the new product now, or wait for few months in order to finish up with the stock of old product. If the company continues to sell the old product following would be the profit position:
 

Particulars

Amount

Selling price

2020

Direct materials costs

480

Direct labour costs

610

Variable overhead costs

245

Total cost per unit

1335

Operating profit per unit

685

The above calculation includes only the relevant cost which will be incurred only if the older model OS1 is continued to be sold.

In the above profit calculation we have ignored development cost and marketing and administration cost, as they are irrelevant cost. These costs have already been incurred and hence are irrelevant in decision making.

Also, if we consider the opportunity cost of new model OS2 for $ 568, the older model would still earn profits of $117 (685-568).

Particulars

Amount

Profits from OS1

685

Less: Opportunity cost- revenue lost from OS 2

568

 

117

Therefore, the management should sell the existing units of older model OS1 first, and then start selling the newer model OS2.

The management should take the decision based on thorough research. They should consider both the qualitative and quantitative factors before taking a final decision. Following are few qualitative factors which should be taken into consideration for decision making:

Wastage of existing materials/stock- if the management has already purchased the materials or already has the stock of products, then steps should be taken to ensure the consumption of such units. Making decision only on the basis of profits will lead to loss and wastage of resources.(Atkinson, 2012)

Market demand- if the company is willing to wait to sell the product, it should make sure that the demand of such product would exist in the future. If there is no expected demand for the new product in future then it would be of use to the company to wait. If the new product is launched during Christmas it would definitely create huge demand and awareness in the market.(Boyd, 2013)

Changes in technology- the management should also study market to ensure that the new technology used by it won’t be outdated by the time it launches its new product. Obsolete of the technology will make the launch of new product a waste.(Datar S. , 2016)

Effect on reputation of the company- launching product with developed feature before the competitors can help the management create goodwill for the company. Waiting to launch a product with improved technology might give the competitors a chance to move forward and create the similar product.(Datar M. S., 2015)

Therefore, when the management takes the final call on launch of new model of the helicopter, it should make sure to consider all the factors mentioned above along with the profitability mentioned in part a.

In order to evaluate the effect of sale of 4000 more units of tables on the Caleta division, we have calculated the incremental cash flows:

Particulars

Amount

Revenues (250*4000)

1000000

Variable direct materials and direct labour costs (150*4000)

600000

Depreciation on equipment used exclusively for this batch

95000

Marketing and distribution costs (750*80)

60000

Operating profit (loss)

245000

In the above calculation we have not taken into consideration the general administration and corporate office cost, as these costs will not be affected by our decision. These are irrelevant costs which will remain same irrespective of our decision.

Therefore, if the division is to sell extra 4000 tables, it would help them generate $245000 incremental cash flows. The overall cash flows of the division will be as follows:

Particulars

4000 Tables

24000 Chairs

4000 tables

Total

Revenues

 10,00,000

 20,00,000

10,00,000

40,00,000

Variable direct materials and direct labour costs

 6,00,000

 10,50,000

 6,00,000

22,50,000

Depreciation on equipment used exclusively by each product line

 84,000

1,16,000

95,000

 2,95,000

Marketing and distribution costs:

 

 

 

-

$80 000 (fixed) + ($750 x 80 shipments)+($750 x 80 shipments)

 1,40,000

 

60,000

 2,00,000

$202 500 (fixed) + ($750 x 90 shipments)

 

2,70,000

 

 2,70,000

General administration costs of the division allocated to product lines on the basis of revenue

 2,20,000

4,40,000

-

 6,60,000

Corporate office costs allocated to product lines on the basis of revenues

 1,00,000

2,00,000

-

 3,00,000

Operating profit (loss)

 -1,44,000

-76,000

 2,45,000

25,000

Therefore, the overall profitability of the division would increase to $25000 from $220000 loss if extra 4000 tables are sold. Hence we would recommend the company to sell extra 4000 units of table in order to ensure profitability.

In this case we have to analyse if the company should keep operating the said division or shut it down. To come at a conclusion we have calculated costs under both the alternatives:

 

Costs if the division continues to work:

Particulars

4000 Tables

24000 Chairs

Total

Revenues

 10,00,000

 20,00,000

30,00,000

Variable direct materials and direct labour costs

 6,00,000

 10,50,000

16,50,000

Depreciation on equipment used exclusively by each product line

 84,000

1,16,000

 2,00,000

Marketing and distribution costs:

 

 

 4,10,000

$80 000 (fixed) + ($750 x 80 shipments)

 1,40,000

 

$202 500 (fixed) + ($750 x 90 shipments)

 

2,70,000

General administration costs of the division allocated to product lines on the basis of revenue

 2,20,000

4,40,000

 6,60,000

Corporate office costs allocated to product lines on the basis of revenues

 1,00,000

2,00,000

 3,00,000

Operating profit (loss)

 -1,44,000

-76,000

-2,20,000

Therefore, if the division continues to work it would incur a loss of $220000

If the division is shut down, then it would incur no expense in relation to production. But the fixed costs will still be incurred. Shutting down the division will save the general administration cost but the corporate office cost will still be incurred. The corporate office costs are allocated to the division based on the revenues. Since the Caleta Division would shut down and generate no revenues, no part of corporate office cost will be allocated. Hence there would be no profit no loss from the division if it is shut down.

Therefore we have the following:

Operating Profit/(Loss) when

 - Business Continues

-220000

 - Division shut down

0

 Hence based on above calculations, the division should shut down as it would help the company save $220000.

Irrelevant costs are costs which are to be eliminated or not to be considered in the decision making process. (Horngren, 2012)

Irrelevant costs are those costs:

  • Which have already been incurred
  • Which have already been committed
  • Which would not change irrespective of any decision
  • Which will not result in any cash outlay in case of decision making process
  • Which will be incurred at the same rate under any circumstance(Seitz & Ellison, 2009)

Therefore any costs having any of the above criteria will be classified as irrelevant cost.

 

References

Atkinson, A. A. (2012). Management accounting. Upper Saddle River, N.J.: Paerson.

Boyd, W. K. (2013). Cost Accounting For Dummies. Hoboken: Wiley.

Datar, M. S. (2015). Cost accounting. Boston: Pearson.

Datar, S. (2016). Horngren's Cost Accounting: A Managerial Emphasis. Hoboken: Wiley.

Horngren, C. (2012). Cost accounting. Upper Saddle River, N.J.: Pearson/Prentice Hall.

Seitz, N., & Ellison, M. (2009). Capital Budgeting and Long-Term Financing Decisions. New York: Thomson Learning

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