Question

Sun Systems Ltd. is considering installing a new heating system in its factory to provide heating and power.

Details are as follows:

1. The existing heating system will cost £8,000 to remove, and has no value. If retained, the existing heating system has an expected life of a further 5 years.

2. The new heating system will cost £57,000 including installation expenses of £2,800.

3. The current heating system costs £22,000 per year in energy, £8,000 per year in maintenance and £2,000 per year in depreciation.

4. The new heating system would cost £12,000 per year in energy, cost nothing to maintain in the first 2 years (as it would be under guarantee) and £3,000 per year for the remaining life.

5. The new heating would be depreciated in the accounts on a straight line basis over the life of 5 years. There is no expected residual value.

6. At the end of 5 year period, both old and new heating systems would have the same cost of removal.

7. The company’s cost of capital is 10%.

8. All annual costs can be assumed to occur in arrears.

• Calculate the net present value of the new system and recommend whether the new system should be installed.    

Mikey Limited uses Target costing when developing new products. A new product is being considered which has the following costs and revenue information:

Sales: the demand is expected to average 5,000 units per month at a selling price of £7.00 per unit  

Materials:  the product requires 0.5 kg of material T for each unit

Labour:    each unit requires 6 minutes of labour at £14 per hour  

Overheads:  the product would be manufactured in a separate factory, with total fixed production overheads of £10,000 per month

Profit :the gross margin required is at least 25%

• Calculate the Maximum cost per kilo for material T which company will be ready to pay.  

• Comment on whether standard costing applies in both manufacturing and service businesses and how it may be affected by modern initiatives of continuous performance improvement and reduction.   

Answer 1

a. Net Present Value for new healing system

	0th year (out flow)	1st year (out flow)	2nd year (out flow)	3rd year (out flow)	4th year (out flow)	5th year ( out flow)
removal cost for existing heating system	8000
cost for new heating system	57000
cost for energy		12000	12000	12000	12000	12000
cost for maintenence				3000	3000	3000
cost for removal of new healing system						8000
total	65000	12000	12000	15000	15000	23000

NPV = 65000 + 10909 + 9917 + 11270 + 10245 + 14281 = 135903

NPV for old heating system

	1st year (out flow)	2nd year(out flow)	3rd year ( out flow)	4th year (out flow)	5th year (out flow)
cost for energy	22000	22000	22000	22000	22000
cost for maintenence	8000	8000	8000	8000	8000
cost for removal					8000
total	30000	30000	30000	30000	38000

NPV =27273 + 24793 + 22593 + 20490 + 23595 = 118744

Its better to use existing heating system instead of instaling new heating system. because npv of new heating system is greater than existing heating system.. so the total cost of new heating system is higher than existing.

b. Maximum cost per kilo for material T which company ready to pay is

Selling price = 5000 untis * 7 /unit = 35000

material = .05 * 5000 * cost/ kilo = 2500 * cost/kilo

Labour = 14 for 1 hour.. 6 minutes required. so for 6 minutes = 14/60 = .233.

.233*6 = 1.398

5000*.233*6 = 6990

Fixed overhead = 10000

gross profit margin = 25%

cost for material per kilo =

selling price - 35000

material -

Labour - 6990

Over head - 10000

gross profit - 8750 (35000*25/100)

so. 35000 - 6990- 10000 - 8750 = 9260

material cost = 9260, cost/kilo = 9260/2500 = 3.704

c. Standard costing is best suited activities within service organisation but it can be applied to activities within service organisation where output can be measured and there are clearly defined input / output relationships.