Question

Two proposals for manufacturing a new product have been proposed to the board of directors of ‘Salamis’ Ltd. Market research indicates that there is strong demand for the product.

Proposal 1: The company will acquire plant costing £900,000. Fixed expenses (other than depreciation) would amount to £570,000 per annum and variable expenses per unit would be £350.

Proposal 2: The company will acquire plant costing £800,000. Fixed expenses (other than depreciation) would amount to £240,000 per annum and variable expenses per unit would be £400.

In both cases the plant is expected to last five years and to have no scrap value. The straight-line method of depreciation is considered appropriate. The finished product will be marketed for £500 per unit irrespective of the level of sales. The forecast level of demand is 6,000 units per annum. The working capital requirement amounts to £50,000 under each proposal.

Required:

1. For each proposal calculate the break-even position in units each year.

(b)      Demonstrate and explain which proposal carries the minimum risk to the business.

(c)      For each proposal calculate the contribution and the expected profit.

(d)      State which proposal should be accepted and give your reasons including a commentary on both risk and return considerations.

(e)      ‘Contribution analysis described in the text books is too simplistic and it is of little relevance to management’. How far do you agree with this statement?

Answer 1

	(a)	PROPOSAL 1
		Cost of Plant	£        900,000
		Annual Depreciation(900000/5)	£        180,000
		Other Fixed Expenses	£        570,000
		Total Fixed Costs	£        750,000
		Unit Sales Price	£                500
		Variable cost per unit	£                350
		Unit Contribution Margin(500-350)	£                150
		Breakeven point in units=Total Fixed Costs/Unit Contribution Margin
		Breakeven point in units=750000/150	5,000
		PROPOSAL 2
		Cost of Plant	£        800,000
		Annual Depreciation(800000/5)	£        160,000
		Other Fixed Expenses	£        240,000
		Total Fixed Costs	£        400,000
		Unit Sales Price	£                500
		Variable cost per unit	£                400
		Unit Contribution Margin(500-400)	£                100
		Breakeven point in units=Total Fixed Costs/Unit Contribution Margin
		Breakeven point in units=400000/100	4,000
	b)	Proposal 2 carries lower risk to business
		The Breakeven point is lower
		Probability of loss is lower
	c)	CONTRIBUTION AND EXPECTED PROFIT
		PROPOSAL 1
	A	Unit Contribution Margin(500-350)	£                150
	B	Level of demand in units	6000
	C=A*B	Annual Contribution	£        900,000
		Expected Profit =Contribution-Fixed Costs
	D	Fixed Costs	£        750,000
	E=C-D	Expected Profit	£        150,000
		PROPOSAL 2
	A	Unit Contribution Margin(500-400)	£                100
	B	Level of demand in units	6000
	C=A*B	Annual Contribution	£        600,000
		Expected Profit =Contribution-Fixed Costs
	D	Fixed Costs	£        400,000
	E=C-D	Expected Profit	£        200,000
	d)	Proposal2 has higher expected profit
		It has lower risk
		Proposal2 should be accepted
	e)	Contribution Analysis does not take into consideration the Time Value of Money