Last updated: September 14, 2019
Topic: BusinessManufacturing
Sample donated:

 

 

Universal Research LLC
Task 1: Analyse financial performance
a)          Evaluate the underlying reasons for the improvement in net operating income in 2006.  How far will the profit be sustainable?

Answer:

In 2006, the operating income of the Clayton business improved when he conducted the market research. He realized that for every ten –cent cut in the selling price he can have his sales jump up to addition 5,000 kilogram of papers.

He therefore decided to reduce the selling price from 2.70 to 2.50 in order to increase this sales revenue. The result was positive and the sales revenue increased to $225,000 as compare to the last year revenue of $ 216,000.

 

Another reason why net operating income in 2006 improved was because although     there were a price cut but at the same time there was no increase in the expense of   the company , the expense was proportional to the unit sold .

 

The third reason was the capacity to producing 90,000 kilogram of commodity    graded papers which increased the operating income of the company by $ 9,000 as        compare to corresponding year income of 16,000 only

In 2006 , Clayton company was able to manufacture 90,000 units at $ 2.5 per      unit .In future if he wants to increase his sales revenue by 10000 units , he will    have to reduce the price to $2.3.This is the maximum output Clayton company       can manufacture keeping in mind the production capacity of the company . At this             level of production , the following will happen

 

Sales

@ $2.30 per kilogram                                                                       $230,000

Less cost of goods sold:

Beginning inventory                                                                             40,000

Cost applied to production:

Variable manufacturing costs:

Direct materials (@ $0.60 per kilogram)                                              60,000

Conversion variables (@ $0.30 per kilogram)                                      30,000

Fixed manufacturing overhead                                                          110,000

Cost of goods manufactured                                                              200,000

Goods available for sale                                                                     240,000

Less ending inventory                                                                          40,000

Cost of goods sold                                                                             200,000

Under-applied or (over-applied) fixed overhead cost                                   0

Adjusted cost of goods sold                                                              200,000

Gross margin                                                                                        30,000

Less non-manufacturing fixed overhead                                             20,000

Net operating income                                                                         $10,000

By looking at the level , it can be said that with the decrease in price of the product operating income has fallen to $10,000 . which means that the profit of 25,000 is not sustainable with the price of $ 2.3 per kilogram

b)          Comment on the financial performance of Clayton’s business for the year of 2006.  Contrast it with the 2005 result and justify your comment with appropriate accounting ratios.

Answer : Performance Ratio :

Profit Margin for 2006 =       Net Income ( Operating Income ) / Net Sales

Profit Margin for 2006 =       25,000/225,000

= 11 %

Profit Margin for 2005 =       Net Income ( Operating Income ) / Net Sales

Profit Margin for 2005 = 14000 / 216,000

= 6 %

Asset Turnover : measures how efficiently a company uses its assets to generate sales

Asset Turnover for 2006 = Net Sales / Average Assets

Asset Turnover for 2006= 225000 / ( 20000+40000)

=7.5 times

 

Asset Turnover for 2005 = Net Sales / Average Assets

Asset Turnover for 2005= 216,000 / ( 20000+20000)

=10.8 times

Task 2: Manage finance as a resource
a)          Based on the 2006 result, assess whether Clayton’ business is sustainable without diversification from the perspective of working capital management.

Answer :

After the assessment of the result in 2006, it can be said that the Clayton’ business is      sustainable without diversification as the difference between Current Asset and          Current Liability is enough to make the company run smoothly .

Working Capital = Current Assets – Current Liability.

Working Capital = 85000- 15000

= $70,000

 

More ever the Asset Turnover Ratio of the company stood at 7.5 times , which is            again a health sign for the company .

 

b)          Suppose Clayton chooses not to accept the supplier’s equity investment and any bank loan.  Apply an appropriate financing technique to evaluate whether it is financially viable to acquire the new milling machine with the hire purchase scheme.

 

If Clayton chooses to acquire the new milling machine with the hire purchase scheme, he will have to pay an extra amount of $144,000           –  $120,000 = $ 24,000 .

Other than that as it was written in the passage that he has to pay an immediate down-payment of $ 5000. And the remaining balance in 5 equal annual instalments then ,

Total cost – Down payment = Balance to be paid in 5 years time

$144000 – $5000 = $ 139000

 

Distributing the balance to 5 year = $ 139000 / 5 = $ 27,800.

= $ 27,800 is the per year cost

If the new machine is made to operate at full capacity then , 80000 unit of commodity paper would be produced . If this happens then the Fixed Manufacture cost would be distributed as 22,000 for art papers and 88,000 for commodity graded papers . This will make up to exactly $ 110,000.

Moreover , if we calculate , we can find that the difference between the selling price and the variable cost would be =           $ 3.6 – ( 1+ .3) = $ 2.3

This $ 2.3 per kilogram would make up to = 2.3 x 20000 kilogram =  $ 46,000 for the company . From 46,000 Clayton would have to pay the Fixed Manufacturing cost and also the annual instalment which will become

= $ 46000 – 22000 (Fixed Manufacturing cost ) – 27800 (Annual Instalment )

= $ (3,800)

This means that after covering the Fixed manufacturing cost and the annual instalment payments , Clayton company would be in a loos of $ 3,800 .

All the above calculations proves that it is not financially viable to acquire the new milling machine with the hire purchase scheme.

Task 3: Make financial decision
a)          Plot and calculate the break-even point and the margin of safety (both in units and in dollars) for the years of 2005 and 2006 (ignore beginning and closing inventory).  Evaluate to what extent the breakeven analysis is a useful pricing tool for Clayton’s business.

Revenue

 
Total Cost

Sales

 

Break Even Point of 2006

191000

 

 
Fixed Cost

110000

 
110000

68750                                  Units

 

 

 

Revenue

 
Sales

Total Cost

Break Even Point of 2005

 

 

 
110000

 
61111                                     Units

n Breakeven Analysis is assumes that fixed costs (FC) are constant

n In Break even analysis Clayton has assumed hat average variable costs will be constant              per             unit of output, but it is not generally possible

n In break even analysis we assumes that the quantity of goods produced is equal to the                quantity of goods sold so here Clayton we have to see if the all the goods produced are             sold .

In break even analysis we assume that there is no opening or closing inventory , but here in     Clayton company we have seen some opening and closing inventory lying up .

Sales

b)          Critically comment on the validity of Clayton’s pricing policy of maximising his sales revenue with reference to the 2006 result and the projected 2007 one.  Recommend the best pricing strategy with justifications.

 

Answer :

the increase in operating income to 25,000 was a success to the Clayton’s business . He not only utilized his unused capacity of production but also gained the market share by lowering the price .to $ 2.5. The contribution to fixed cost was also lowered .

 

Clayton on the other hand if continue to pursue the same pricing policy in 2007 , then the result will not be the same as it was in 2006 as now the operating income would only be 10000 that is less than the operating income in 2006 .

 

Clayton should continue using this $ 2.3 per kilogram pricing strategy because this is the best option he has keeping in mind the contribution to fixed cost , operating income and production capacity of the company . Clayton should also keep in mind that lowering price is not the only way to generate sales and capture market share but there are other ways also such has increase in efficiency of the labour ,

 

c)          Assume that the diversification project into the “art papers market” is viable, what is and appropriate selling and production strategy?

Answer :

Production Strategy :Clayton would have to take up some of the strategy in order to make a profit in the arts paper market , the strategies are listed below

·         Inventory , he will have to keep an eye on the inventory position of the arts paper to make sure that inventory are not pilled up unnecessarily . This is beacuase it may add to the opportunity cost of the Company .

·         Supplier , Clayton would have to build good and long term relations with his supplier so that the supplier will also be ready to supply Clayton the raw material , Here Clayton may paper a supply chain management concept .

·         Labour , Clayton in order to maximize profit should make sure that the labours are efficient in producing art papers , and also effective in a sense that they should make good quality papers .

Selling Strategy :

Clayton should take up the following selling strategy .

·         promotion strategy should be development so that all the customers are well informed about the product , this will increase the sales of art paper .

·         Price of the art paper may be increase if the demand for art paper is high .

 

 

d)         Based on the above identified selling and production strategy, apply suitable investment appraisal techniques with explanation to determine the viability of Clayton’s diversification project.  You should duly consider all mentioned financing options.  Make and justify your recommendations.

 

Task 4: Choose sources of finance
a)          What factors, both quantitative and qualitative, should Clayton consider in choosing among the financing options in the diversification project?

Answer :

Clayton is faced with three options .

Equity Investment :

Clayton should consider that when he will  financing through equity investment  , the investor ( supplier ) has asked him to give at least 14 % return over his investment . This may become quite expensive for Clayton .

 

3.6 – ( 1 +.3 ) = 2.3 will be distributed to the fixed cost of the company i.e. the instalment

2.3 x 20000 = 46000  will be the revenue generated  through  selling 20000 kilogram of art paper .

Out of 46000 , $ 22000 will be contributed to the Fixed manufacturing cost = 24000

From the amount left Clayton will have to give 14% to the supplier which will become $ 16800.

24000- 16800 = $ 7200 will be the amount that he will be earning. It should be noted here that this amount $ 7200

Will only be generated if all 20000 kilogram of art papers are sold.

Apart from that if he accept this offer of the supplier , the supplier may take part in the decision making which Clayton may do not like . This may trigger a conflict between the two .

It may also be possible that supplier may reject supplying goods to Clayton as an result of the conflict .

 

Bank Loan :

Bank loan is absolutely not feasible because first he is not getting the total amount that is 120000 , which means he has to investment extra amount  using his cash .

120000 – 50000 = 70000  will be paid from the cash .

70000 extra is required to buy the machinery which by looking at the balance sheet of the company is not possible , since he has only $ 7500 in his cash account .

Apart from that taking bank loan may increase his liabilities and increase the debt to equity ratio of the company ..

 

Hire Purchase :

Hire purchase is not also feasible because here he will be incurring a 3800 loss ,

3.6 – ( 1 +.3 ) = 2.3 will be distributed to the fixed cost of the company i.e. the instalment

2.3 x 20000 = 46000  will be the revenue generated  through  selling 20000 kilogram of art paper .

Out of 46000 , $ 22000 will be contributed to the Fixed manufacturing cost = 24000 .

In hire purchase  method he will have to pay an extra of 24000 . He will also have to pay 5000 down payment .

Calculation :

144000-5000 = 139000

139000 / 5 =  $ 27800 will be the annual instalment of the Company .

 

Out of 24000 when he will be giving out 27800 he will be left with = 24000-27800 = 3800 loss .

 

Hire Purchase he also not feasible because after the instalment will ended after 5 years , there will be no worth of the machinery ( salvage value ) .

Which means Clayton would incur a double loss first from giving out instalment in the 5 years and also after 5 years when he will realize that the salvage value of the machinery is zero.

b)          If Clayton decides to accept the equity investment of the supplier, describe all available organisation structures.  Recommend the most appropriate type of organisation structure to Clayton

Answer :

 

The only organization structure that would exist if Clayton would accept the equity investment of the supplier is a partnership . Here in this scenario the partnership will be of 52 % : 48 % as capital of Clayton would be 130000 and supplier would invest 120000 .

c)          Conclude your report by systematically summarising all your findings and recommendations

Answer :

Clayton is currently in the commodity graded paper market , he had found out that with every 10 cent decrease in price , there was an increase in demand of 5000 kilogram of commodity graded paper . He also plans to decrease 20 cents to maximize his output to 100000 which is the maximum capacity of his company .

But By calculation it was found out that if he decrease the price further than the operating income would fall .therefore to make a good operating income a price of $ 2.5 per kilogram should be kept . It should also be noted that Clayton is planning to operate at full capacity which is usually not possible . One of the many reason why companies cannot operate at full capacity is the breakdown of the machines . Any breakdown may interrupt the production and so producing at full capacity will not be achieved .

Clayton Also sees that their is a huge demand of art paper ,To start manufacturing art paper he must have the art paper machine .Here he is faced with three of the financing facilities available to him . One is hire and purchase , Second is a bank loan and the last one is the equity investment by his supplier .

 

With Careful calculation it was found out that he would incur a loss of $ 3800 , if he avails hire and purchase financing facility .  If he avails bank loan then he will have to give 70000 from the cash which at this point is not possible since he only have $ 7500 in his cash account . If he accepts to avail the equity investment from his supplier , the company would be able to make a profit at the same time the supplier would become the partner of Clayton  with a profit share of 52 % : 48 % . It is very important to note that these calculations were based on the fact that the company is producing 20000 kilogram of art paper and 80000 gram of commodity paper .

 

If Clayton diversify his business he will have to take up some production and seeling strategy like making sure that the labours are well trained and efficient , Promoting the art paper to the customer with a careful study of his needs .

 

Here i would recommended that he plans not to diversify then he should continue to sell the commodity paper at $ 2.5 which will earn a high operating income as compare to any other price . If he diversity he should avail equity financing because this is the only way in which he is earning profit.

 

References :

Tim Jackson (1993). Clean Production Strategies. CRC-Press.