Abby Plc is a manufacturing company with operations in Birmingham, UK. The company has enjoyed relative success in the past. However, in recent years, it has been reporting significant losses. As a result, it is now being suggested that the company be liquidated if there is no turn around in its fortunes in the next three years. You have just joined the company on a six-month work experience. Your first impression of the company suggests a very motivated workforce, dedicated customers and a unique brand offer. You query why such a company should be having financial problems. You glean from discussion with your new colleague, John (one of the trainee accountants), that the companys financial problem is directly related to its costing system and investment appraisal approach.

A management consultant team has now been called in to address the identified weaknesses of the firm, along with the Accounts Department. You are lucky to find a seat at the table at one of the meetings. Your role is primarily to provide the necessary data and briefing to the team of management consultants. You are excited by the opportunity to demonstrate your knowledge of (management) accounting. The following are extracts of the data you are expected to work with.

Exhibit 1: Indirect manufacturing labour costs, machine-hours and direct manufacturing labour-hours for Product N123.

	Indirect manufacturing labour cost (000)	Machine hours	Direct manufacturing hours
	y	X1	X2
1	1690	73	35
2	1711	93	40
3	1504	67	41
4	1417	77	25
5	1270	65	52
6	1956	101	50
7	1680	83	49
8	1210	51	42
9	1816	87	75
10	1820	99	35
11	1252	73	34
12	1463	53	43

Exhibit 2: Cash flow Estimates of three (3) of the firms recent projects

	Life	Initial Investment	Cash Inflow
X	5	386,400	120,000
Y	10	519,200	120,000
Z	15	609,000	120,000

Required:

A1: You suspect that the choice of an appropraite cost driver may partially explain the companys financial problem. Using Exhibit 1 write a report to your line manager evaluating the difference, if any, in the choice of cost driver for establishing the products indirect manufacturing labour cost. Your report should be based on the qualitative and quantative analysis of the data to include (but not limited to):

1. Estimation of the firms cost functions using regression analysis and high-low method;
2. Prediction of the firms costs at machine hours of 80 hours and a discussion of the reliability or otherwise of your prediction;
3. A discussion of the criteria for choosing an appropriate cost driver;
4. A discussion of any assumptions you have made in (a) above;
5. Evaluation of the methods of estimation specified in (a) above.

(20%)

A2 The company uses the payback period and accounting rate of return methods to appraise its project; the simplicity of these methods is attractive to management. You recently come across a study suggesting that similar companies as Abby Plc use more sophisticated methods based on time value of money. You believe that a more reliable project appraisal could be made using any of the discounted cash flow methods. It is difficult to calculate the firms cost of capital but similar companies typically require a minimum return of 10% on equity finance. Abby Plc is an all-equity financed firm.

Required

Prepare a second report to management on its investment appraisal options. Your report should include:

(A2i) A discussion of discounted cash flow methodologies and their assumptions.

(A2ii) A quantitative analysis of each of the projects above using any two (2) discounted cash flow methods. (Also discuss the implications of your figures).

(A2iii) A brief section discussing the treatments of working capital, scrap value, depreciation, taxes, capital rationing, unequal project lives, and inflation in investment appraisal.

(20%)

A3 Discuss why and how the choice of investment appraisal method and cost driver may partly explain a firms reported performance.

(10%)