RISK PROFILE OF THE COMPANY
The targeted sale of ABC is $ 3 million in three years where as currently the company’s sales are 1.2 million. The company CEO is thinking to increase the sales by more than twice and as an entrepreneur this is an aggressive strategy which needs to be weighted in terms of its perceive risk factors. Following may be the factor which may affect the success of this strategy:
a. There is a risk that product might not be up to meet the expectations of a customers.
b. Change always face reluctance, the new product will be subject to the acceptability risk of a customer.
c. Risk of competition follows the launch of new product, may result in loss of market share by the company.
d. Production depends upon the factors of production, the new product requires a different raw material which is required to be purchased from outside supplier. To find the correct and cheap raw material for the product is also a major task for the company. Further the reliability in supply is crucial for the success of business
e. Impact of inflation on the profit of the product is a foremost problem which company might be facing in the upcoming years. Inflation is the key element which management fails to foresee and may result in price fluctuation.
f. Human resource is the vital part of product development and current human resource might not be able to meet the technical requirements of the new product. The company would be required to hire human resource for the new product. Finding right people is also a major risk for the company
CURRENT COMPANY CASH FLOW
ABC COMPANY
CASH FLOW STATEMENT (direct method)
December 31, 20X2
Received from customers / $ 1,260,000Paid to Suppliers / $ (830,000)
Paid for expenses / $ (250,000)
Paid for taxes / $ -
Cash flow from operating activities / $ 180,000
Purchased fixed assets / $ (100,000)
Cash flow from investing activities / $ (100,000)
Paid for dividend / $ (100,000)
Cash flow from financing activities / $ (100,000)
Overall change in cash flows / $ (20,000)
Opening Balance of cash / $ 70,000
Ending Balance of Cash / $ 50,000
SOURCES AND USES OF COMPANY FUNDS
The purpose of Cash flow statement is to identify the sources of cash flow in the company and how the cash is spent or invested over a specified period of time. Non-cash item are excluded from the cash flow to give the true financial performance.
Operating activity results in surplus cash of $ 180,000 which has been invested to acquire capital assets of $100,000 for future expansion purposes. Further, to meet the expectations of shareholders the company has paid out dividend of $100,000. The company has surplus opening balance of $70,000; resultantly the ending balance remains $50,000.
IMPROVEMENT OF CASH FLOW
Although the current cash position of the company is positive. The company has generated positive cash flow from the operations. The same has been invested in fixed asset for the future expansion of the company, resulting in higher sales.
Although the shareholders are expected to be paid by it is advisable to review the dividend distribution policy of the company to retain the surplus for financing the future growth.
PROJECT FINANCING
As the current position of the company is quiet sound enough to finance the current project. Further the company has made investment in fixed asset for the expansion of the business. If company maintains the same cash position the external source of financing would not be required by the company.
Further in order to reduce the discount rate the ABC can consider the option of raising funds from debt financing only in order to reach an optimal capital structure.
ADDITIONAL FINANCING
Financing can be by either debt or equity. Debt financing has the benefit of fixed pay out and tax shield. In debt financing the interest expense is allowable expense resulting in low tax expense, where as in case of equity finance the cost of equity is dividend, and no advantage can be availed in tax.
The company position is strong enough so its better that company should use debt financing instead of equity financing.
NEW PRODUCT COST
PRODUCT COST FOR THE EXPANSION
The product cost per unit under absorption costing is $15.00 and under variable costing are 10.60.
Direct Materials / $ 5.60 / $ 5.60
Direct labor dollars needed per product / $ 4.00 / $ 4.00
Variable Factory Overhead / $ 1.00 / $ 1.00
Fixed Factory Overhead / $ 4.40 / S -
Product Cost Per Unit / $ 15.00 / $ 10.60
IMPACT OF EXPANSION ON PRODUCT COST
One of the major benefits of expansion is the reduction of fixed cost (fixed and selling). The cost is absorbed by 85,000 units instead of 80,000 units resulting in saving of $0.42 per unit.
AFTER EXPANSIONFixed Factory Overhead before expansion / $ 2.48 / $ 2.20
Fixed Selling Expense / $ 2.39 / $ 2.25
Total / $ 4.87 / $ 4.45
Price would fallen by / $ 0.42
SELLING PRICE
The target of the company is to achieve 40% gross margin. So calculating the price of a product under absorption costing, the selling price of a product would be $25 per unit.
Calculation of a product cost: cost of a product / Cost of goods sold percentage
$15/ 0.6 = $25 per unit
CONTRIBUTION MARGIN AND BREAK EVEN POINT
Breakeven point in dollars is $590,539 and the overall contribution margin is 66% and it we assume that the total overall sales mix will not change then product wise breakeven is as follows
EXISTING / NEW / TOTALSales / $ 1,160,000 / $ 125,000 / $ 1,285,000
Variable cost / $ (384,000) / $ (54,000) / $ (438,000)
Contribution Margin / $ 776,000 / $ 71,000 / $ 847,000
Contribution Margin Ratio / 66%
Breakeven point / $ 533,093 / $ 57,445 / $ 590,539
POTENTIAL INVESTMENT
NET PRESENT VALUE
Ignoring the taxation and depreciation the NPV is $1,366 negative.
YEAR / CASH FLOW / DISCOUNTED @ 12%0 / $ (42,000) / $ (42,000)
1 / $ 15,000 / $ 13,393
2 / $ 13,000 / $ 10,364
3 / $ 10,000 / $ 7,118
4 / $ 10,000 / $ 6,355
5 / $ 6,000 / $ 3,405
Net Present Value / $ (1,366)
DEPRECIATION IMPACT
The depreciation of purchase of new equipment on the basis of straight line would be $8,400 each year. The tax rate is not given so it will not affect the cash flows, hence we ignored the depreciation impact. Depreciation is only relevant in a scenario where tax needs to be paid, as it is a tax allowable expense and the effect of tax shield needs to consider.
Acceptance of investment:
Project is viable if net present value of its cash flows is positive, in the given scenario the cash flows of the project are positive over the period of time however when cash flows are discounted at the discount rate of 12% the overall NPV is negative $1,366. Hence it is not advisable to undertake the project.
Conclusion
Major Risk Factors:
The company is having quiet aggressive approach for the increase of sales. The company intends to increase the sales by 2.5 times, which is quiet high. The launch of new product is also quite risky, as the company would require more labor, market knowledge about the product would be required, complete knowledge about the product such as raw material, processing time of the product etc. Further if the product fails no back up plans are prepared. What would be the effect on company if the product fails? The management needs to consider the above mentioned risk thoroughly.
RESPONSIBILITY AS THE CONTROLLER AND A MANAGEMENT ACCOUNANT:
During the execution of a project, procedures for project control and record keeping become indispensable tools to managers and other participants in the construction process. These tools serve the dual purpose of recording the financial transactions that occur as well as giving managers an indication of the progress and problems associated with a project. Management accountant must synthesize a comprehensive view from the different reports on the project plus their own field observations. In particular, managers are often forced to infer the cost impacts of schedule changes, further they should do the probability analysis to determine the projects ability to deal with the above mentioned risks.
In order to provide complete scenario the Controller should undertake extensive exercise to gather information about the sales increase and investment in a new product before making any conclusion.
Recommendation
Before implementing the project the management should use different analytical techniques to make the product successful. Further, the complete market knowledge, labor skill required for the product and the material cost should be considered.
After the detailed analysis of the new launch of product considering the future cash flows are positive the project should be accepted else it should be rejected.