Question from the Chartered Institute of Management Accountants, Stage 3 Management Accounting Applications, May 1997. (45 minutes)

DEF Ltd produces fuel pumps that are incorporated in petrol engines produced by a number of other companies. At present DEF Ltd produces three different versions of its standard fuel pump—versions D, E and E Rapier Management Consultants have recently been engaged by DEF Ltd to undertake a value analysis and engineering exercise concerning the design of the fuel pumps.

Rapier have proposed that the three different versions of the fuel pump be replaced by a single general-purpose unit, known as version X.

The main features of this proposal are:

© it will be possible to dispose immediately of equipment and buildings at a price of £120,000 and there will be no additional development costs;

® total annual unit sales will initially drop by 25% from their existing level but will thereafter grow at 4% per annum compound;

© it will be possible to make a £250,000 initial reduction in the value of component and finished goods stock; stocks will thereafter grow at a rate of 2% per annum compound;

® the variable cost of producing one unit version of X will be £1.75 less than that of producing versions D, E and FE If the proposal is not adopted and production of units D, E and F continues, then it is forecast that unit sales and stocks will both grow at an annual rate of 3% compound. The market price of a fuel pump is £48 and the variable cost of producing one unit of D, E or F is £35. At present

(before the Rapier proposal is implemented), DEF Ltd’s stocks have a cost of £560,000 and annual sales of D, E and F total 18,000 units.

DEF Ltd appraises projects using a 10% discount rate and an eightyear time horizon.  mki8 REQUIRED 1. Explain why the redesign of DEF Ltd’s product may have the effects claimed for it by Rapier Management Consultants; explain the general principles of value analysis. (7 marks)
2. Advise DEF Ltd’s management on the merits of the Rapier proposal;
support your advice with a full financial evaluation. (9 marks)
3. Draw a diagram to illustrate the sensitivity of the Rapier proposal to the reduction in unit variable cost (claimed to be £1.75); identify the minimum reduction in net variable cost needed to make the proposal viable and indicate this point on your diagram. (9 marks)
Total marks = 25 Advanced level