Question

RS p.1.c. manufactures domestic food mixers. It is investigating whether or not to accept a three-year contract to make a new model for sale through a supermarket chain. The contract uses skilled labour which cannot be increased above that currently available and RS p.1.c. will receive a fixed price of £42 per mixer for all the mixers it can produce in the three-year period. The following estimates have been made:

Capital investment £50000 payable now, with nil scrap value.

Additional overhead £25000 per annum.

Materials £30 per mixer Labour £6 per hour.

The factory manager knows from experience of similar machines that there will be a learning effect for labour. He estimates that this will take the form:

y = ax^-0.3

where y = average labour hours per unit

a = labour hours for first unit

x = cumulative production

He estimates that the first mixer will take 10 hours to produce and that the fixed amount of labour available will enable 5000 mixers to be produced in the first year. Apart from the capital investment, all cash flows can be assumed to arise at year ends. The company has a cost of capital of 15%.

Conduct a sensitivity analysis to support the decision-making process.

Answer 1

	Sensitivity analysis of Profit for new model of food mixers of RS p.1.c.
	Description	Price Per Unit	Option 1 (5000 U)	Option 2 (5500 U)	Option 3 (6000 U)
	Revenue	42	210,000	231,000	252,000
	Less:
	Direct Material	30	150,000	165,000	180,000
	Direct Labour	W. N. 1	23,400	22,440	22,680
	Overheads	-	25,000	25,000	25,000
	Depriciation		16,667	16,667	16,667
	Profits from Business		(5,067)	1,893	7,653
	Return on Capital Invested		-10.13%	3.79%	15.31%
	Notes-
	1) Average Labour Cost per unit
	Description		Option 1	Option 2	Option 3
	Total Units Produce in first year (x)	5000	5500	6000
	Labour Hours for First unit (a)		10	9	8.5
	Average Labour hours per unit (y)	0.78	0.68	0.63
	As per question -y = ax-0.3
	Average Labour Cost per unit (£6 X y)	4.68	4.08	3.78

If situation go as per the factory manager experience than we will incur loss in the first year however profit will come in second and third year based on the labour hours and mixer produced during the year. But for getting return upto the cost of capital company i.e. 15% has to manufacture 6000 units at average labour hour per unit 0.63 hrs i.e. 38 minutes approx (0.63 X 60 Minutes) or combination to be at Break even point.