Unit 5 - Chapter 5 - Cost-Volume-Profit Relationships

Many of you are familiar with Amazon. In its second year of operations, sales increased eightfold. Two years later, sales were $1.6 billion. Although its sales growth was impressive, Amazon's ability to lose money was equally amazing. One analyst nicknamed it Amazon.bomb, while another, predicting its demise, called it Amazon.toast. Why was it losing money? The company used every available dollar to reinvest in itself. It built massive warehouses and bought increasingly sophisticated (and expensive) computers and equipment to improve its distribution system. This desire to grow as fast as possible was captured in a T-shirt. This buying binge was increasing the company's fixed costs at a rate that exceeded its sales growth. At one point, the company predicted its sales would increase by at least 28% in a given quarter, but that its operating profit would decrease by at least 2% and perhaps by as much as 34%. How might this scenario be used in a CVP analysis situation, and how might Amazon have modified its spending to increase profits in conjunction with increasing sales?

An oil company is considering upgrading a reaction furnace in one of its natural gas plants. The company’s engineers have outsourced two alternative systems. The upgrades will be more energy efficient and will save the company money in fuel – since burner technology has improved greatly since the original plant was built. However, the new upgrade will have additional annual operating, maintenance and utility costs. Each of the alternatives (Furnace A and Furnace B) has a 10 year service life and because these are specialized systems, the salvage value will be zero. The capital costs and the annual savings and other annual costs are estimated in Table 1.

Table 1

a) Calculate the NPV of each alternative if the MARR is 8%. Which alternative would they choose?

b)   Calculate the IRR of both these furnaces.

(Note: Within 1% is fine) For example, IRR is between 11 and 12%)

5. Consider the following project data: A Shs 2 million feasibility study will be conducted at t =0. If the study indicates potential, the firm will spend Shs 10 million at t= 1 to build a prototype. The best estimate is that there is an 80% chance that the study will indicate potential and 20% chance that it will not. If reception of the prototype is good the firm will spend Sh. 350 million to build a production plant at t=2. The best estimate is that there is a 70% chance that the prototypes’ reception will be poor. If the plant is built, there’s a 60% chance of a t=3 cash inflow of Shs 300 million and a 40% chance of Shs 150 million cash inflow. If the inflow at t=3 is Shs 300 million, there are 30% and 70% chances of Shs 160 million and Shs 90 million inflows respectively at t=4. If the inflow at t=3 is Shs 150 million, there are 80% and 20% chances of Shs 210 million and Shs 140 million inflows respectively at t=4. The plant has a salvage value of Shs 50 million at t=5. If the appropriate cost of capital is 15% what is the project’s expected NPV?

In 2018, the Marion Company purchased land containing a mineral mine for $2,050,000. Additional costs of $843,000 were incurred to develop the mine. Geologists estimated that 490,000 tons of ore would be extracted. After the ore is removed, the land will have a resale value of $100,000.

To aid in the extraction, Marion built various structures and small storage buildings on the site at a cost of $205,800. These structures have a useful life of 10 years. The structures cannot be moved after the ore has been removed and will be left at the site. In addition, new equipment costing $77,500 was purchased and installed at the site. Marion does not plan to move the equipment to another site, but estimates that it can be sold at auction for $4,000 after the mining project is completed.

In 2018, 59,000 tons of ore were extracted and sold. In 2019, the estimate of total tons of ore in the mine was revised from 490,000 to 577,500. During 2019, 89,000 tons were extracted, of which 69,000 tons were sold.

Required:

1. Compute depletion and depreciation of the mine and the mining facilities and equipment for 2018 and 2019. Marion uses the units-of-production method to determine depreciation on mining facilities and equipment.

You have been hired as a financial consultant to Defense Electronics, Inc (DEI). The company is looking to set up a manufacturing plant overseas to produce a new product line. This will be a five-year project. The plant will be built on land already owned by DEI. That land could be sold today for $5.3 million. If the company pursues the project, the value of the land is projected to be $5.7 million in five years. The plant will cost $32 million to build and the project will require an initial net working capital investment of $1.3 million. This $32 million will be depreciated straight-line to zero over the five years of the project, but will be able to be scrapped for $3 million. The plant is expected to generate pre-tax “sales minus costs” each year of $12 million.   The tax rate is 35%. Find WACC and use as the discount rate to find the NPV. You have the following information regarding the firms’ sources of financing:

-There are 230,000 7.2% coupon bonds outstanding with 25 years to maturity and a YTM of 6.8%.

-There are 8.8 million shares outstanding, selling for $71 per share. The beta is 1.1

-The market risk premium is 7% and the risk-free rate is 5%.

Can you please form a balance sheet and income statement with the information:

Start-up costs for the business will require a large amount of expenses. First a section of land will need to be purchased. This area is expected to be 500ft2. This is a sufficient quantity of space to build the warehouse where will growing will be undertaken. The warehouse will be 300ft2. This size means there will be enough room for all business activities such as growing, organizing and distribution to occur. The block of land will be purchased in the rural Hamilton area, ten minutes’ drive from the CBD. The projected cost of the land along is $500,000. The cost to build the warehouse will be a further $1M, this will include the cost of erecting the building and all other expense’s related to its construction. The combined $1.5M will be funded through bank loans and government funding, which will cover approximately $100,000

Once the land and warehouse is built, operations will begin and other expenses will need to be accounted for. Electricity, internet and telephone will be the greatest expense worth $3000 per month. This is mainly due to the high usage of UV lighting throughout the plant to grow the cannabis. Staff wages will account for $500,000, $50,000 annually and ten staff employed. Operating expenses will be $10,000 yearly, this is for advertising and marketing. Depreciation of all machinery assets is calculated by 10% p.a straight-line method. These machines will cost $500,000 to purchase and used assist the growth cycle of the cannabis. Cost of goods sold per year will equal $275,000, this is mainly the seeds which are imported for growth. Revenue is projected to be $1.5M annually.

Overall, the start-up costs for the business will be $2M. To pay for this, $100,000 will be funded by the government and the remaining sum of $1.9M will be loaned from a bank over 10 years. Interest is 5% and loan repayments per year will be $190,000 add interest.

Assets of the company are land, valued at $500,000. Warehouse, valued at $1,000,000. Machinery, valued at $500,000 deprecated using straight line method at 5%.

Accounts receivable is $50,000.

Accounts payable is $125,000.

Question 1 Impact of changing price upon revenue and profit

A suburban factory makes three types of motorcycles. Each type of motor is made of engine parts and two wheels. The factory uses three brands of engine parts – Chrome Catalyst, Platinum Power and Silver Streak.   Motorcycles are built and sold as follows;


Type 1 -Chrome Catalyst engine parts
Type 2 Platinum Power engine parts
Type 3 Silver Streak engine parts Cost of engine parts $876 $1228 $1024 Cost of wheels (each) $65 $65 $65 Sale price range $1000 - $1200 $1400 - $1600 $1200 - $1400


Regardless of the type of engine parts used to make a motorcycle, there are fixed production costs of $4000.

Your task is to investigate the cost, revenue and profit associated with each type of motorcycle.


Steps to complete to undertake the investigation

1. Find the total cost and total revenue functions for each type of motorcycle and plot these functions using Excel. You will produce 3 graphs (one for each motorcycle type), each with two lines on it. For the revenue function, select a price for each motorcycle type within the price ranges in the table above.


2. Confirm any points of intersection between the cost and revenue function lines using algebra, round your final answer up to the next whole number.

3. Profit will also differ for each motorcycle type. Find the profit functions and the break-even points for each type of motorcycle.

4. Summarise your findings in 200 words. In your conclusion:

a. Explain the meaning and significance of any points of intersection noted from steps 1 and 2 and any similarities noted from you results in step 3. b. Discuss any differences in profitability between each type of motorcycle (for example, which motorcycle type would be easiest to make a profit from?) c. Note any assumptions you have made and any limitations of your findings.

You are the senior human resource professional in a company and part of the senior strategic management team. The company is a service company that operates five teleprofit centers of 300 representatives each in the following Florida cities: Jacksonville, Orlando, Gainesville, Tampa, and Miami. The CEO has asked the senior strategic team to develop a HR plan that will allow the company to grow by two more teleprofit centers, which will be located in Jacksonville, Florida. Considering turnover, length of training, hiring success and learning curve for new employeesdevelop a reasonable “hire ahead” plan, which keeps newly trained employees ready to take the place of employees who leave or are promoted to other positions. The “hire ahead” plan must allow no more than 3% of the employee base in each of the new teleprofit centers to consist of newly trained employees. The following factors should be considered while developing the plan: • There is a human resource budget of $3.5M. • From the HR Budget, $200K will be dedicated for recruiting and selection. • Recruiting costs will increase by 30%, but the HR budget will not increase. • Recruiting will be conducted through Monster, CareerBuilder, Sologig, and in various print publications in the listed cities. • There will be 4500 applications received per month from the recruiting efforts. • Average turnover of the teleprofit representatives in the company is 7% per month. • Average turnover of the teleprofit representatives in Jacksonville is 5% per month. • New representatives receive two weeks of training in the classroom and two weeks of “side-by-side” training before they are on their own. • All trainer positions are exempt. • It takes nine months for a representative to be considered “fully trained”. SELECTION PROCESS Choose as many, or as few, of the following steps to create the selection process that applies best to your plan. All applicants who pass these steps will be hired. o Pre-screening- performed by a human resource assistant (nonexempt position) - cost of $20 per applicant; 95% of applicants prescreened are successful and are passed on to a recruiter. o Interviewing- completed by a recruiter (exempt position) - cost of $70 per applicant; 50% of applicants who are interviewed are successful and are then tested. o Employee testing- administered by a human resource assistant- cost of $30 per applicant; 50% of those tested are successful and will have a drug screening check done. o Drug screening- coordinated by a human resource assistant- cost of $35 per applicant; 95% will have a successful drug screening and then have a background check completed. o Background check- coordinated by a human resource assistant using a third party contracted provider- cost of $25 per applicant; 60% will have a successful background check and will be submitted to a credit check. o Credit check- conducted by a human resource assistant-cost of $35 per applicant; 60% will fail the credit check. ISSUES TO ADDRESS The following list represents a minimum guideline of issues that should be addressed:  How does this current hiring process affect the successful filling of current position vacancies?  What process changes can be made to help your budget concerns?  How many new employees have to be hired each month to meet the objectives of the “hire ahead” plan?  What is happening to the vacancy rate?  What is the vacancy rate?  What can be done to improve your vacancy rate?  What can be done to understand the turnover rate?  What can be done to improve the turnover rate?  How does this scenario affect the bottom line of the company?

I am having trouble answering these 2 questions. What is the vacancy rate? What is happening to the vacancy rate? can u please write 2 detail paragraphs for each question. (Thanks)

John’s Custom Computer Shop (JCCS) assembles computers for both individual and corporate customers. The company is organized into two divisions: Personal and Business. Once a computer is built, it is shipped to the customer. Billing for all customers is handled by the corporate Accounts Receivable Department. Accounts Receivable performs two major activities: billing and dispute resolution. Billing refers to preparing and sending the bills as well as processing the payments. Dispute resolution occurs when a customer refuses to pay, usually due to an error in billing.

The costs of the Accounts Receivable Department are allocated to the two divisions based on the number of bills prepared. Kyle, the manager of the Business division, has complained that the allocated costs from Accounts Receivable are beginning to make the business division look unprofitable and has asked you to recommend some changes to the allocation system. If he agrees with your recommendation, he will pass them on to the chief financial officer.

Data on costs and activities in the Accounts Receivable Department follow.

The Accounts Receivable Department incurred the following costs during the year.

Required:

a. Under the current allocation system, what is the cost that will be allocated from Accounts Receivable to Personal? To Business?

b. Suppose the company implements an activity-based cost system for Accounts Receivable with two activities, billing and dispute resolution. What is the cost that will be allocated from Accounts Receivable to Personal? To Business? Use the number of bills prepared as the cost driver for billing costs and the number of disputes for dispute resolution costs.

Under the current allocation system, what is the cost that will be allocated from Accounts Receivable to Personal? To Business? (Do not round intermediate calculations.)

Suppose the company implements an activity-based cost system for Accounts Receivable with two activities, billing and dispute resolution. What is the cost that will be allocated from Accounts Receivable to Personal? To Business? Use the number of bills prepared as the cost driver for billing costs and the number of disputes for dispute resolution costs.

McCormick & Company is considering a project that requires an initial investment of $24 million to build a new plant and purchase equipment. The investment will be depreciated as a modified accelerated cost recovery system (MACRS) seven-year class asset. The new plant will be built on some of the company's land, which has a current, after-tax market value of $4.3 million. The company will produce bulk units at a cost of $130 each and will sell them for $420 each. There are annual fixed costs of $500 thousand. Unit sales are expected to be $150,000 each year for the next six years, at which time the project will be abandoned. At that time, the plant and equipment is expected to be worth $8 million (before tax) and the land is expected to be worth $5.4 million (after tax). To supplement the production process, the company will need to purchase $1 million worth of inventory. That inventory will be depleted during the final year of the project. The company has $100 million of debt outstanding with a yield to maturity of 8 percent, and has $150 million of equity outstanding with a beta of 0.9. The expected market return is 13 percent, and the risk-free rate is 5 percent. The company's marginal tax rate is 40 percent.

1. What will be the tax depreciation each year?

2. What will be the value of the plant and equipment for tax purposes in year six? Will it be sold for a gain or a loss, and what will the tax effect be?

3. What is the weighted average cost of capital (WACC)?

4. What is the salvage cash flow of the new equipment? Include the income tax effect.

5. What is the total operating cash flows, given the following operating cash flows:

Sales = 150,000 x $420 = $63,000,000

Costs = 150,000 x $130 + $500,000 = $20,000,000