Innovate Ltd specialises in the development and production of innovative products. As their products usually have relatively
Question:
Innovate Ltd specialises in the development and production of innovative products. As their products usually have relatively short life cycles, the company must generate a continuous stream of new products in order to survive. The dynamic nature of Innovate Ltd's operations has led some members of senior
management to question the relevance of traditional budgeting for the company. However, other more
forceful members of senior management insist that the company continues to engage in a traditional
budgeting process; while acknowledging the difficulties of forecasting sales and estimating costs they
believe budgets are critical for planning and control. Prior to engaging in the annual budget process, each
division must determine the projects in which it will engage for the forthcoming period.
Division A
Division A is one of the company's production divisions. Most of the production staff employed in Division
A have been with the company since its inception and are extremely experienced. At the employees' own
request, production tasks are normally allocated between them so that the same people work on a
particular product throughout its life cycle.
Assessing the Financial Viability of Product Alpha - Division A's New Product
Management of Division A are currently assessing the financial viability of a new product called Product
Alpha. The marketing manager believes that, depending on the level at which the selling price is set, this
product may have either a one year or a two year life cycle. The company will only proceed with Product
Alpha if either with a one year life cycle the net cash inflow equals or exceeds 20% of the initial investment,
or with a two year life cycle the net cash inflow equals or exceeds 40% of the initial investment. Innovate
Ltd define the net cash inflow as sales less production expenses less the initial investment. Management
do not wish the time value of money to be taken into account for these calculations.
Product Alpha
Irrespective of whether a one year or two year life cycle applies, the marketing manager anticipates that 48,000 units of Product Alpha will be sold in each year. Market research suggests that Product Alpha will have a life cycle of one year if its selling price is set at €66 per unit but that its life cycle will extend across two years if its selling price is set at €50 per unit.
Product Alpha would be produced in batches of 250 units on a just-in-time basis, with production volumes equalling sales volumes in each year. Based on previous experience with similar products, the production manager expects that a 90% learning curve will apply to the production of Product Alpha over the first year of production. A steady state production time requirement will apply after this point, with labour time per batch stabilising at that of the final batch of year 1. It is expected that 200 hours of direct labour time will be required for the first batch produced in year 1. A direct labour rate of €25 per hour applies within Division A.
Direct material cost is estimated to be €4,000 per batch of Product Alpha for the first 80 batches. The next 80 batches are expected to cost 95% of the initial batch cost. All batches produced thereafter are expected to cost 95% of the batch cost for each of the second 80 batches.
Fixed production overheads of €220,000 per annum will be incurred directly in respect of Product Alpha. Product Alpha will require an initial investment of €l,500,000 with no residual value, irrespective of the life of the product.
Division B
Division B is another of the production divisions within Innovate Ltd. As the products produced by this division tend to be very different to one another, there is great variety in the range of tasks required of staff within Division B. The production manager in Division B is a firm believer in the merits of maintaining a multi-skilled and flexible staff and moves staff between tasks and between products as much as possible. However, he fears that the emphasis he places on staff development may be somewhat counter- productive. Division B's employees are highly sought after by competitors and as a consequence the division suffers a very high staff turnover with many employees only staying for 6 months. Having heard that the learning curve is used in estimating costs within Division A, the production manager in Division has begun to wonder if it could be usefully applied in estimating the costs of products produced within his division.
The formula for a 90% learning curve is yx = ax-O.1520
Requirement
Prepare a memorandum for management of Innovate Ltd in which you:
(a) Indicate whether Product Alpha will generate the target net cash inflow over:
(i) the 1 year time frame;
(ii) the 2 year time frame.
You should support your conclusions with suitable calculations.
(b) Calculate the initial labour hours per batch which would need to apply in the production of Product
Alpha so that the net cash inflow would exactly equal the target level for the 1 year time frame. You
should assume that all variables, except the initial labour hours per batch, remain as outlined above.
(c) Comment on the applicability of the learning curve in the context of Division B.
Financial Accounting Theory and Analysis Text and Cases
ISBN: 978-1118582794
11th edition
Authors: Richard G. Schroeder, Myrtle W. Clark, Jack Cathey