Daisy Limited

Daisy Limited

Daisy Limited is considering embarking on a project to manufacture a new product, the JK. A feasibility study recently undertaken at a cost of $170,000 (yet to be paid for), has recommended that the selling price for the JK should be $70 each for the next sixteen years. It further indicated that at least 5,000 units of the product could be sold annually.

Annual overheads of the proposed project are expected to be as follows:

$
Variable overheads 86,000
Depreciation 100,000
Factory rentals 24,000
Head office charges 60,000
Salaries 196,000
Totals 466,000

NOTES
1. The salaries figure of $196,000 consists of the following:

Current salary of supervisor from head office $45,000
Responsibility allowance of the supervisor for taking charge of JK production $9,000
Senior manager’s current salary $96,000
Salary of assistant manager who will be recruited specifically for the project $46,000

In the event that the project does not start for any reason, the senior manager will be retired and a new manager will be recruited at an estimated salary of $90,000 per annum.
2. Production equipment is expected to cost $1 million with no scrap value at the end of 16 years. Daisy Ltd charges depreciation at an estimated rate of 6.25% per annum on cost.
3. Because direct labour is in short supply, labour resources would have to be diverted from work which currently earns a contribution of $2/hr.
4. Product JK will be produced in an already existing factory which the company is currently renting for $24,000 per annum. This figure is subject to an increase of 10% per annum.
5. Daisy absorbs its fixed overheads at the rate of $5 per direct labour hour. However actual expenditure on fixed overheads would not alter.
6. The estimated cost of capital of Daisy is 10% per annum in real terms.

7. The cost of one unit of the JK is expected to be as follows:

$
Direct Labour 3hrs @$4.5/hr 13.50
Materials 2kg @ $3.5/kg 7
Variable overheads 2hrs @$2.15/hr) 4.30
Fixed overheads (including depreciation) 2hrs @$5/hr 10
TOTAL 34.80

The directors of Daisy Limited are unsure of whether or not to proceed with the manufacture of the product.

As the consultant of Daisy Limited, you have been approached by the managing director to provide financial advice to the board of directors.

Required:

a) Provide relevant computations to show whether or not the company should proceed with the manufacture of the product on financial grounds. (Report format not required). (10 marks)
b) Explain the term “relevant costs” and provide reasons for your treatment of the various costs in part (a). (6 marks)
c) Measure the sensitivity of the project to changes in the following variables:
i. Sales volume (2 marks)
ii. Sales price (2 marks)

[Total: 20 Marks]