3 Cash was particularly limited this year and acceptance of this project could mean that other projects would have to be deferred. How should this be taken into consideration? Roger Davis, the newly appointed financial analyst of the Steel Tube division of Engineering Products plc, shut his office door and walked over to his desk. He had just 24 hours to re-examine the accountant’s profit projections and come up with a recommendation on the proposed new computer numerically controlled (CNC) milling machine.

At the meeting he had just left, the managing director made it quite clear: ‘If the project can’t pay for itself in the first three years, it’s not worth bothering with.’ Davis was unhappy with the accountant’s analysis which showed that the project was a loss maker. But as the MD said, ‘Unless you can convince me by this time tomorrow that spending £240,000 on this capital project makes economic sense, you can forget the whole idea.’

His first task was to re-examine the accountant’s profitability forecast (Table 6.11) in the light of the following facts that emerged from the meeting:

1 Given the rapid developments in the market, it was unrealistic to assume that the product had more than a four-year life. The machinery would have no other use and could not raise more than £20,000 in scrap metal at the end of the project.

2 The opening stock in Year 1 would be acquired at the same time as the machine. All other stock movement would occur at the year ends.

3 This type of machine was depreciated over six years on a straight-line basis.

4 Within the ‘other production expenses’ were apportioned fixed overheads equal to 20 per cent of labour costs.

As far as could be seen, none of these overheads were incurred as a result of the proposal.

5 The administration charge was an apportionment of central fixed overheads. 

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Year 1 2 3 4 400 600 800 600 Sales Less costs Materials Opening stock Purchases Closing stock 40 80 80 60 260 300 360 240 (80) (80) (60) - Cost of sales 220 300 380 300 Labour 80 120 120 80 Other production expenses 80 90 92 100 Depreciation 40 40 40 40 Administrative overhead 54 76 74 74 Interest on loans to finance the project 22 22 22 22 Total cost 496 648 728 616 Profit (loss) (96) (48) 72 (16)